Bailout Policy and Risk-Taking Behavior

• I am especially indebted to Robert Marquez for many insightful discussions. I am also grateful to Larry Ausubel, and Steven Ongena for their comments and suggestions. Any remaining errors are my own. Abstract We set up a model to analyze the banks' risk-taking and funding decisions (between insured and uninsured funds), in a regulatory framework that includes both unfairly priced deposit insurance and bailout policy. First the model predicts that it is possible for risk to decrease (increase) after an increase (decrease) in the probability of bailout. This is due to the fact that the bank reacts to the reduction (increase) in the cost of uninsured funds to raise a significantly higher (lower) proportion of uninsured debt, making the liability mix more (less) sensitive to risk. This may lead to an optimal decision to reduce (increase) risk. This negative relationship between risk and probability of bailout is more likely the more elastic the supply of insured funds. Second, the model shows that an increase in risk is a necessary condition for the proportion of insured deposits to increase, suggesting that regulators and/or practitioners could use this ratio as a warning signal to help them detect those cases in which risk undoubtedly increases.