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Too-Many-To-Fail and the Design of Bailout Regimes

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  • Wolf Wagner
  • Jing Zeng

Abstract

We show that the too-many-to-fail problem can be resolved through an appropriate design of the bailout regime. In our model, optimal investment balances benefits from more banks investing in high-return projects against higher systemic costs due to more banks failing simultaneously. Under a standard bailout regime, banks herd, anticipating that simultaneous failures trigger bailouts. However, a policy that prioritizes bailing out a predesignated group of banks eliminates herding and achieves the first-best. If such a policy is not feasible, its benefits can be attained by decentralizing bailout decisions to two regulators each responsible for a separate group of banks.

Suggested Citation

  • Wolf Wagner & Jing Zeng, 2024. "Too-Many-To-Fail and the Design of Bailout Regimes," CRC TR 224 Discussion Paper Series crctr224_2024_613, University of Bonn and University of Mannheim, Germany.
    • Handle: RePEc:bon:boncrc:crctr224_2024_613
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    File URL: https://www.crctr224.de/research/discussion-papers/archive/dp613
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    References listed on IDEAS

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    More about this item

    Keywords

    systemic risk; optimal investment; too-many-to-fail; time-consistency; bailouts;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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