Does Size Matter? Bailouts with Large and Small Banks

Abstract

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Strategic Liquidity Mismatch and Financial Sector Stability

“…Additionally, the estimate in Column (2) of Table 9 shows that such mimicking behavior is relatively stronger among larger banks. This is consistent with large banks taking more risk than small banks in equilibrium since they internalize that their decisions directly affect the government's optimal bailout policy (Dávila and Walther, 2018), but also with risk-taking being driven by the presence of RPE in compensation schemes that tends to be more prevalent in larger banks (Ilic, Pisarov, and Schmidt, 2017;Albuquerque, Cabral, and Guedes, 2019). 22 This finding is particularly important given that the trade-off between liquidity creation and fragility is most consequential for large banks that create the most liquidity (Berger and Bouwman, 2009).…”

“…Additionally, such mimicking behavior is relatively stronger among larger banks. This finding is not only consistent with large banks taking more risk than small banks in equilibrium since they internalize that their decisions directly affect the government's optimal bailout policy (Dávila and Walther, 2018), but also with risk-taking being driven by the presence of RPE in compensation schemes that tends to be more prevalent among larger banks (Albuquerque, Cabral, and Guedes, 2019).…”

“…Both are driven by LOLR bailout guarantees that may lead to excessive risk-taking in the form of excessive liquidity mismatch and correlated risk. Similarly, Dávila and Walther (2018) show that large banks take more risk than small banks in equilibrium since they internalize that their decisions directly affect the government's optimal bailout policy. In addition, free-riding in information acquisition is likely to be driven by a leader-follower model in which small banks' liquidity mismatch choices are affected by the decisions of large banks, but not vice versa.…”

Incomplete Information in Macroeconomics: Accommodating Frictions in Coordination

“…Allowing the small players to observe the actions of the large player further amplifies this property. Davila (2012) studies the role of a different type of large players in a different context: the role of large banks in the context of the subprime crisis. The starting point of the analysis is Farhi and Tirole (2012), who identified the following collective moral hazard problem: because the government is more likely ex post to bailout an individual bank when the entire banking system is in trouble, each bank is ex ante more willing to expose itself to an aggregate risk when it expects other banks to do the same.…”

“…In Farhi and Tirole (2012), this collective moral hazard problem is modeled as a complete information coordination game that ultimately features multiple equilibria: one with low "systemic risk" and another with high. 43 By contrast, Davila (2012) uses a global-game adaptation to obtain a unique equilibrium. The presence of large banks is shown to intensify the severity of the collective moral hazard problem, increase economy-wide leverage, and make the crisis occur for a large set of fundamentals.…”