Economic Quarterly

In this article, we describe a time-consistency problem that can arise in the government's policy toward insolvent financial firms. We present this problem using a simple model in which shareholders of a large financial firm can raise low-cost debt financing and take on an excessive amount of risk. If this risk backfires, there are spillover effects harmful to the economy as a whole. In such a crisis event, the government's best action is to bail the firm out. The prospect of this bailout is the very reason why the firm can raise debt at low cost while taking on excessive risk. Given the structure of this problem, we discuss government policy that can eliminate or mitigate excessive risk-taking. Efficient resolution policy can eliminate excessive risk-taking only if it can completely eliminate the negative spillover effect. Alternatively, excessive risk-taking can be eliminated either directly by accurate government supervision of system-wide risk-taking, or indirectly by imposing binding capital requirements.