Safety-net benefits conferred on difficult-to-fail-and-unwind banks in the US and EU before and during the great recession

This paper investigates the links between regulatory arbitrage, financial instability, and taxpayer loss exposures. We model and estimate ex ante safety-net benefits from increased leverage and asset volatility at a sample of large banks in US and Europe during 2003-2008. Hypothesis tests indicate that, in both crisis and precrisis years, difficult-to-fail-and-unwind (DFU) banks enjoyed substantially higher ex ante benefits than other institutions. Compared to the US sample, safety-net benefits prove significantly larger for DFU firms in Europe and bailout decisions are less driven by asset size. Introducing a proxy for differences in government susceptibility to regulatory capture helps to explain bailout decisions in Europe. Our findings suggest that authorities in both venues could better contain safety-net benefits if they refocused their information systems on monitoring volatility as well as capital.

► We model safety-net benefits as credit enhancements from expected bailouts. ► We value taxpayer puts for US and European banks in crisis and precrisis years. ► We compare the value of the puts across time, countries and bank size classes. ► We show that method's predictive power could help supervisors to lessen systemic risk. ► Weekly reporting of bank balance sheets would enhance our method's usefulness.