Bank bailouts: moral hazard vs. value effect

The traditional approach to the central bank's lender of last resort function emphasizes the trade-off between being too 'tough', and thus increasing the likelihood that the failure of a single bank hampers the confidence in the whole banking system, and being too 'soft', thereby creating incentives for banks to take on excessive risk. In contrast with this view, we show that a central bank, by announcing and committing ex-ante-to bail out insolvent institutions in times of adverse macroeconomic conditions, can create a risk-reducing 'value effect' that outweighs the moral hazard component of the policy, and thus lowers bank risk. (C) 2003 Elsevier Inc. All rights reserved.