Banks without Parachutes – Competitive Effects of Government Bail-out Policies

The explicit or implicit protection of banks through government bail-out policies is a universal phenomenon. We analyze the competitive effects of such policies in two models with different degrees of transparency in the banking sector. Our main result is that the bail-out policy unambiguously leads to higher risk-taking at those banks that do not enjoy a bail-out guarantee. The reason is that the prospect of a bail-out induces the protected bank to expand, thereby intensifying competition in the deposit market and depressing other banks’ margins. In contrast, the effects on the protected bank’s risk-taking and on welfare depend on the transparency of the banking sector.