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Trading for Bailouts

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In times of high uncertainty, governments often implement interventions such as bailouts to financial institutions. To use public resources efficiently and to avoid major spillovers to the rest of the economy, policy-makers try to identify which institutions should receive assistance. One important source of information is activity in stock markets: high prices generally indicate expected high profits; low prices reflect expected poor performance. With this price information, policy-makers can infer the market’s perception of the financial health of publicly traded companies and whether they need assistance. However, this “learning from the market” has a potential obstacle: some market participants (e.g., large creditors and shareholders) may have special interests in the government intervention. Prices in financial markets may therefore not only reflect overall information about the firm’s financial health but also speculators’ incentives to influence government decisions.

We study how the presence of traders who may benefit from a government intervention affects the informativeness of prices in the stock market as well as the incidence and efficiency of bailouts. We propose a theoretical model in which a policy-maker decides whether to provide assistance to a financial institution. The policy-maker tries to collect information about the firm’s financial condition from its stock price. We show under which conditions, and to what extent, the policy-maker can increase the efficiency of interventions by relying on stock market information.

Our results indicate that the presence of large traders with high stakes in the government intervention reduces the informativeness of stock prices. Government bailout decisions are therefore less efficient. We also show that a higher cost of implementing bailouts can actually increase welfare. If the policy-maker is more reluctant to intervene, speculators will have less incentive to trade strategically to affect its decisions. The gains in market informativeness can more than compensate for the higher implementation costs. A gradual implementation of bailouts also improves learning from the market.