Bank risk-taking and optimal bailout resources

We develop a model in which regulators determine optimally the resources
they commit to bank bailouts, balancing the costs of bailouts against those of bank failures. Banks, on the other hand, balance the costs of reducing their risk with the benefits of bailouts. We find that as the costs of risk reduction increases, the actual risk taken reduces, also reducing the need for bailouts. The reason for our counterintuitive result is that as these costs increase for banks, the regulator reacts by reducing bailouts and thus induces an actual reduction in risks taken by banks. Similarly, we find that increasing the costs of not bailing out banks reduces bank risks and the resources committed to bailouts.