Efficient Bailouts? - 2012 Institute events - Dallas Fed

This paper develops a non-linear DSGE model to assess the interaction between ex-post interventions in credit markets and the build-up of risk ex ante. During a systemic crisis, bailouts to the financial sector relax balance sheet constraints and accelerate the economic recovery. Ex ante, the anticipation of such bailouts leads to an increase in risk-taking, making the economy more vulnerable to a financial crisis. We find that the optimal intervention in the economy requires a bailout of around two percentage points of GDP during a credit crunch. We also show how bailouts may increase financial fragility in the absence of prudential policy.