The evolution of risk and bailout strategy in banking systems

Abstract

In this paper we analyse the long-term costs and benefits of bailout strategies in models of networked banking systems. Unlike much of the current literature on financial contagion that focuses on systemic risk at one point in time, we consider adaptive banks that adjust risk taking in response to internal system dynamics and regulatory intervention, allowing us to analyse the potentially crucial moral hazard aspect associated with frequent bailouts. We demonstrate that whereas bailout generally serves as an effective tool to limit the size of bankruptcy cascades in the short term, inappropriate intervention strategies can encourage risk-taking and thus be inefficient and detrimental to long term system stability. We analyse points of long-term optimal bailout and discuss their dependence on the structure of the banking network. In the second part of the paper, we demonstrate that bailout efficiency can be improved by taking into account information about the topology of and risk allocation on the banking network, and demonstrate that finely tuned intervention strategies aimed at bailing out banks in configurations with some degree of anti-correlated risk have superior performance. These results demonstrate that a suitable intervention policy may be a useful tool for driving the banking system towards a more robust structure.

Deposit insurance and credit risk of Nigeria banking system: a time series analysis

“…De Caux, McGroarty and Brede (2017) analyzed the long-term costs and benefits of bailout strategies in banking systems. They found that bailouts serve as effective tools that limit the occurrence of bank failures in the short-run.…”

Does Bank Recapitalization Affect the Performance of the Banking Sector? The Empirical Evidence

“…Governments worldwide have launched an extraordinary assisted measures for banks in developed economy Rose and Wieladek (2012), De-Caux et al (2017), and emerging economy (Shehu et al, 2014). In recent time, the authorities all over the world designated for supervision and regulating the banking sector have resolved to a different rescue measures such as extended liquidity support, nationalization of banks, capital injection and blanket guarantees (Bayazitova & Shivdasani, 2012;Duchin & Sosyura, 2014;Berger et al, 2016).…”

Micro-level Evidences of Moral Hazard in the European Financial Institutions

“…Acharya et al (2015) analyze how the capital requirements can address moral hazard problems in banking associated risk shifting and managerial under-provision of effort in loan monitoring. A number of studies (Antzoulatos and Tsoumas, 2014;Cheng et al, 2016;De Caux et al, 2017;Janda, 2009;Mariathasan et al, 2014) points to the evidences of moral hazard behavior of financial institutions in case of various forms of government support i.e. bailout, guarantees, deposit insurance, etc.…”