Market financing of bail-out targets

A bank that needs a public bail-out to avoid liquidation can use financial contracts to provide contingent liquidation rights to investors and force the government to increase public support. Limiting the size of the bail-out before knowing the bank's financial condition decreases welfare if the government is strongly pro-continuation.

► This article analyzes the financing policy of a bank in need of public bail-out. ► Debt and equity issues allocate control rights over liquidation of the bank. ► Debt issues commit the government to supporting the bank and facilitating financing. ► Debt generally increases the bail-out size above the bank's financial needs. ► Commitment to limited bail-out on the part of a pro-continuation government can reduce welfare.