A Model of Optimal Corporate Bailouts - Faculty of Business and ...

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Yet another difference of our model from ? is that inefficient investment in our model doesnot arise because of a debt overhang problem. In fact, we do not view our model as much amodel of banks, as we view it of a model of government bailouts for generic non-bank firms,such as the GM and Chrysler. But like ?, we focus on the socially inefficient aspects of firmbehavior. Bailouts are needed because it is too costly for the firm to finance continuation, giventheir struggle with their own internal moral-hazard (managerial agency) problems. Our paperfocused on on the internal and external moral-hazard problems and their best remedies. Ourdistortive tax effects are endogenous, and not linear as in ?. We also offered specific policyrecommendations (on managerial and owner retention, bailout funding, etc.) different fromthose in ?, and showed that firms and managers—the Chamber of Commerce—will lobby for asystem in which they do not face a priori taxation to cover future bailouts.? and ? study adverse-selection models, in which firms differ in the publicly-unknownqualities of their existing assets. In contrast, our model studies moral-hazard problems in firmswith known assets and opportunities. In their models, the government ends up subsidizing onlythe worst types, whereas in our model, the government ends up subsidizing only the marginaltypes. In their models, the parameterized cost of public funds is exogenous, whereas in ourmodel, the costs of raising bailout revenue (through taxes) is endogenous. This is important,because distortionary taxes (and T 2 , in particular) reduce managerial effort and are thus directlyresponsible for our policy prescriptions. In ?, the acceptance of government assistance sends anegative signal to outside capital market participants, which increases the recipients’ privateborrowing costs outside of the program. ? government objective is to obtain a target levelof investment that is the cheapest to taxpayers. In our model, the government maximizestotal social value instead. Their optimal government intervention is a debt contract. Our’s isa direct subsidy (because any government stake raises the required subsidy to entice privateparticipants). In ?, there is a spillover aspect of bailouts. The bailout of one firm raises the costof the next bailout. Firms become progressively more hesitant to participate as progressivelyweaker banks have already been bailed out before them. Like ?, the government takes stakes inexchange for its subsidy, though in equity and direct purchases of firm assets, whereas in ourmodel, the government should take no such stake. 24There are also pre-2008 crisis papers in the banking literature in which bailouts can bevaluable. For example, in ?, banks would lose socially valuable information if allowed todisappear. In ?, asset prices depend on liquidity, and the government can enhance assetvalues by tapping its effectively unlimited credit. In ?, managers can be reluctant to liquidateunderperforming loans when bank regulators close bankrupt banks aggressively. Bailouts aredesigned to minimize such welfare losses. The classic paper advocating some governmentinvolvement is ?, which showed how the private market can fail and how deposit insuranceor convertibility restrictions can enhance the social outcome. As expected, deposit insurance24 Like us, Tirole suggests “just enough” intervention. Although moral hazard is not central to his analysis, hedemonstrates (as do we) that bailouts can exacerbate moral-hazard concerns. The paper does not derive anoptimal bailout in the presence of moral hazard.28
immediately raises moral-hazard concerns, e.g., as in ?, ?, ?, ?, etc. Ex-ante regulation of thebanking sector is usually recommended as a corollary to ex-post deposit insurance.Similarly, in a long number of papers on the subject of government procurement andintervention, Tirole emphasizes how firms can game the system. For example, in ?, firmscorrelate on exposures in order to benefit more from government bailouts:...the central argument of the paper is that private leverage choices depend on theanticipated policy reaction...An accommodating interest rate policy involves (a) aninvisible subsidy from consumers to banks (the lower yield on savings transfersresources from consumers to borrowing institutions), (b) current costs, such asthe (subsidized) financing of unworthy projects by unconstrained entities, and (c)deferred costs (the sowing of seeds for the next crisis, both through incentives formaturity mismatch, going forward, and the authorities’ loss of credibility)...Wheneveryone engages in maturity mismatch, authorities have little choice but intervening,creating both current and deferred (sowing the seeds of the next crisis) socialcosts.Finally, ? is unusual in that governmental bailouts can backfire even ex-post and themselvescause further insolvencies. Of course, although our paper has not allowed for an additionaldirect waste parameter in the process of government intervention, we do not suggest that oneshould ignore the governmental rent-seeking issues first raised in ? and ?. Although thesepapers raise significant real-world problems, our own view of government intervention, thoughskeptic, is decidedly less pessimistic. Our model’s assumption of an optimizing government wasa useful analysis device, not a description of real life. To the extent that rent-seeking makesgovernment intervention more costly, it shrinks the regions in which governmental interventionis beneficial. However, the main insight—that when social externalities are large, bailouts canbe optimal, and they tend to be better if the managers are dismissed—is robust.As far as know, no other model of bailouts has focused on the positive a priori incentiveeffects of tieing bailouts with managerial dismissals.6 ConclusionIn its final report to Congress in March 2011, the TARP Congressional Oversight Panel (COP)offered the following assessment of the automotive industry bailout:Treasury’s interventions in the automotive industry, in particular, raise moral hazardconcerns. In some ways, Treasury actually mitigated moral hazard through its verystrict approach to these companies: it forced GM and Chrysler to enter bankruptcy, astep not required of other major TARP-recipient institutions. However, the mere factthat Treasury intervened in the automotive industry, rescuing companies that werenot banks and were not particularly interconnected within the financial system,29
Page 1 and 2: A Model of Optimal Corporate Bailou
Page 3 and 4: The U.S. sold almost half of its st
Page 5 and 6: As a practical matter for policy ma
Page 7 and 8: firms. 4 However, if government rea
Page 9 and 10: • A “restarted” project proce
Page 11 and 12: constraints, and budgetary constrai
Page 13 and 14: As long as the firm reinvests, sv
Page 15 and 16: In sum, when restarts are unprofita
Page 17 and 18: managers forced the firm into distr
Page 19 and 20: Consequently, when the optimal bail
Page 21 and 22: government bails out the firm optim
Page 23 and 24: expropriated in case of a bailout.
Page 25 and 26: 4.2 Government Funding Constraints
Page 27: incentives to invest ex ante. When
Page 31 and 32: In other words, if it is too cheap
Page 33 and 34: A.4 Proof of Lemma 2If the replacem
Page 35 and 36: Under this tax regime, however, it
Page 37 and 38: BFiguresFigure 1: The Social Value
Page 39: Figure 3: Change in Critical Level

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