Doubling Down on the Safe(ty) Bet: Bailouts and Risk-Shifting at the Intensive Margin

Abstract

Banks have a significant funding-cost advantage since their liabilities are protected by various government safety nets. We construct a corporate finance-style model that shows that banks can exploit this funding-cost advantage by just intermediating funds between investors and ultimate borrowers, thereby earning the spread between their reduced funding rate and the competitive market rate. This mechanism leads to a crowding-out of direct market finance and real effects for bank borrowers through bank risk-shifting at the intensive margin. That is, banks induce their borrowers to leverage excessively, to overinvest, and to conduct inferior high-risk projects.