Bank bailouts, international linkages and cooperation

Financial institutions are increasingly linked internationally. As a result, financial crises and government intervention have stronger effects beyond borders. We provide a model of international contagion allowing for bank bailouts. While a social planner trades off tax distortions, liquidation losses, and intra- and intercountry income inequality, in the noncooperative game between governments there are inefficiencies due to externalities, a lack of burden sharing, and free riding. We show that, in absence of cooperation, stronger interbank linkages make government interests diverge, whereas cross-border asset holdings tend to align them. We analyze different forms of cooperation and their effects on global and national welfare. 

Banking crises are a frequent phenomenon and their fiscal burden can be substantial. Due to deepened international financial linkages, crises can spread rapidly from one country’s financial sector to another. At the same time, with increased cross-border banking, domestic (non-bank) creditors are more often directly affected when a foreign bank gets into distress. Banking crises have therefore become a more international issue. This research formally studies problems that arise when banks operate across borders while government intervention is still limited by national borders. How should governments deal with banks in distress when their potential bankruptcy concerns depositors from different countries and international balance sheet connections can lead to crossborder contagion? The optimal bailout decision requires striking the right balance between distortions to the real economy from taxation, the losses that arise when banks are forced to sell long-run projects below their value and limiting income inequality within and between countries.

When governments do not cooperate with each other, there are non-optimal outcomes. This research contributes to the debate on the advantages and disadvantages of different cooperation regimes.

Tim Schmidt-Eisenlohr