Financial Crisis Essay

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The private signal determines the government's inclination to bailout of a distressed firm because it is used to assess the source of this financial distress.

If the private signal increases the government's inclination to bailout, the government may have an incentive to lie and send the opposite message, thereby preserving market discipline.

Hence, the government takes a tougher stance, bailing out less frequently than it would without the long-term consideration.

When the prior probability of crisis is high, the former effect dominates.

The economic down turn played a significant role in decline in wealth of consumers, collapse of huge businesses and decline in financial activities.

As a result, the world economy experienced drastic recession which adversely contributed to the debt crisis in the European sovereign society.However, national governments through bank bailouts acted quickly to save these institutions from collapse.Nevertheless, the stock markets around the globe fall drastically.In this model, bailing out a distressed firm influences the belief about the state held by another firm in the later period, yielding two conflicting effects.First, the bailout indicates an increased chance that the economy is in crisis, which discourages the later firm from risk taking.I analyze how these uncertainties as well as a government's desire to control future moral hazard influence a bailout decision.To this end, I develop a two-period model in which the government privately receives a signal on the unknown state of the economy.Second, it signifies an increased likelihood of future bailout, which encourages risk taking.When the prior probability of crisis is low, the latter effect dominates.In the first chapter, jointly written with Yeon-Koo Che and Chongwoo Choe, we focus on observations during the recent financial crisis that financially distressed firms may be reluctant to accept government bailouts for fear that it may signal the weakness of their balance sheets and inhibit future financing.To capture such bailout stigma, we develop a dynamic model in which a firm must finance projects by selling legacy assets.


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