Too Small to Be Saved — Competitive Effects of an Asymmetric Bail-out Policy†

This paper analyzes the effects of a “too-big-to-fail” policy, modelled as a higher bail-out probability from the government for some bank, on the behavior of the privileged bank as well as on the remaining banking sector. Contrary to conventional wisdom, the impact on the large bank’s risk-taking is shown to depend on the opacity of banks, i. e., the particular information structure of the model. In contrast, the intensified market pressure leads to an unambiguous increase in the risk-taking of smaller banks. Moreover, the overall effects on the stability of the financial system and on welfare are shown to be ambiguous. No simple trade-off between competition and stability exists.