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A Theory of Government Bailouts in a Heterogeneous Banking System

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  • Ettore Panetti
  • Filomena Garcia

Abstract

How should a government bail out a heterogeneous banking system subject to systemic self-fulfilling runs? To answer this question, we develop a theory of banking with multiple groups of depositors of different size and wealth, where systemic self-fulfilling runs emerge as a consequence of a global game, and a government uses a public good to bailout banks through liquidity injections. In this framework, we characterize the endogenous probability of a systemic self-fulfilling run, and the conditions under which a full bailout cannot be part of the equilibrium. The optimal bailout strategy should target those banks whose bailout has the largest marginal impact on the probability of a systemic self-fulfilling run, and whose depositors are at the lower end of the wealth distribution.

Suggested Citation

  • Ettore Panetti & Filomena Garcia, 2017. "A Theory of Government Bailouts in a Heterogeneous Banking System," Working Papers w201716, Banco de Portugal, Economics and Research Department.
  • Handle: RePEc:ptu:wpaper:w201716
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    References listed on IDEAS

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    2. Inostroza, Nicolas A. & Pavan, Alessandro, 0. "Adversarial coordination and public information design," Theoretical Economics, Econometric Society.

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    More about this item

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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