Bank Bailouts : Cost of Inability to Commit

I develop a theoretical model for investigating the cost of failure to commit in the provision of bailouts to financial institutions. When a financial institution fails, the fiscal authority often deviates from its ex ante no-bailout commitment: the ex post best response is to bail out. The fiscal authority’s time inconsistency creates moral hazard. I calculate the welfare loss from the failure to commit. In the model, as long as the fiscal authority is able to commit to a predetermined bailout policy, the outcome is typically constrained efficient. Furthermore, a higher probability of bank run is not always welfare reducing. Increased run probability can be beneficial by making financial institutions more cautious, thus decreasing the moral hazard loss. Regulations on short-term interest rates offered by financial institutions can deter moral hazard, particularly when the run probability is small