Abstract

Does financial bail-out destroy incentives? The conventional wisdom says yes. We investigate the question by, first, asking why there is financial bail-out in the first place, then, embedding the question into an environment where financial bail-out is called for, and finally, analyzing a particular mechanism that solves the twin problem of the need for bail-out and the moral hazard thus associated. We show that, when done properly, financial bail-out improves, rather than destroys, incentives. Our analysis sheds light on the experience of China’s financial and real sector development and offers a useful benchmark for understanding bail-out during financial crises in general.