Communicating Bailout Policy and Risk Taking in the Banking Industry

This paper considers the effects of imperfectly communicated information about whether a regulator initiates a bailout program for financially distressed banks. The theoretical framework allows for determining whether, and to what extent, it is optimal for a regulator to be imprecise in communicating its bank bailout strategy. Banks do not only rely on their prediction of the regulator’s action, but also on their beliefs about other banks’ predictions to infer the regulator’s strategy. Results indicate that the regulator may substitute higher capital adequacy requirements for being less precise in communicating whether to initiate a bailout program to maintain risk taking by banks.

Key words: bank bailout support, noisy communication, regulation, risk taking.

JEL Codes: D82, L51.

Working paper no. 277