Are Bank Bailouts Welfare Improving?

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The financial sector bailouts seen during the Great Recession generated substantial opposition and controversy. We assess the welfare benefits of government-funded emergency support to the financial sector, taking into account its effects on risk-taking incentives.

In our quantitative general equilibrium model, the probability of a financial crisis depends on the balance sheet choices of financial intermediaries. Those choices are influenced by capital adequacy constraints and ex ante known emergency support provisions.

These policy tools interact to make financial sector bailouts welfare improving when capital adequacy constraints are consistent with current Basel III regulations. But these bailouts are potentially welfare decreasing when capital adequacy regulations are looser, as they were before the Great Recession.