Bailouts and Risk Management Incentives

In my paper, Bailouts, the Incentive to Manage Risk, and Financial Crises, which was recently conditionally accepted for publication at the Journal of Financial Economics, I develop a model where risk management rules are derived as optimal responses to the adverse risk taking incentives created by bailouts. Additionally, the incentives to undertake a bailout are endogenously determined, making it possible to provide a joint explanation for the observed risk appetite reversals and the prevalence of bailouts.

In the baseline version of the model there are three agents: the firm’s shareholders, its debt holders and a stakeholder. The stakeholder incurs a discrete cost or externality if the firm is terminated. The presence of this cost or externality makes the stakeholder willing to bail out the firm, by injecting funds, once bankruptcy looms. However, the stakeholder’s guarantee to the shareholders is implicit and the benefit from the firm’s continued presence is bounded. Hence, bailouts can occur only if the stakeholder finds it profitable to undertake them. Within this framework, the paper studies the shareholders’ incentive to take risk. As one might expect, the presence of an implicit guarantee makes the shareholders inclined to raise the volatility of the projects that they undertake. However, high volatility choices could deter the stakeholder from bailing out the firm. This produces a tension. On the one hand, shareholders want to raise volatility, but not so much that the stakeholder will find it prohibitively costly to bail out the firm. This tension introduces the need for risk management rules, commitments and regulations that can be either the result of regulation or self-regulation.

A new aspect of the model is that rules, regulations and commitments are allowed to be imperfect. The imperfection stems from the fact that future shareholders may choose to renege by paying a cost. This helps capture situations where firms can circumvent risk management rules by undertaking costly activities such as setting up offshore, off-balance sheet entities. The imperfection of commitment implies that the credibility of a risk management rule is not taken as given. Instead, adherence to the rule has to be dynamically consistent. Within this framework, I analyze the optimal choice of a risk management rule and show that it has a particularly simple form: undertake projects with high risk levels when net worth (defined as assets minus liabilities) is sufficiently high and switch to projects with low risk levels when net worth falls below an endogenously determined threshold. The model shows that risk limits tighten abruptly when the firm’s net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as “flight to quality”.

The full paper is available for download here.