Optimal Bailout of Systemic Banks

Following the recent global financial crisis, there have been many sig- nificant changes to financial regulatory policies. These may have re- duced the likelihood and future cost of the next crisis. However, they have not addressed the central dilemma in financial regulation which is that governments cannot commit not to bail out banks and other fi- nancial firms. We develop a simple model to reflect this dilemma, and argue that some form of penalty structure imposed on key decision- makers post-bailout is necessary to address it.