Bank bailouts and political instability

This paper studies bank solvency crises due to macroeconomic shocks in a model where government is prone to bailout because of cronyism. Citizens can dismiss the government and overrule its decision if they believe that a bailout is not economically justified. The results are as follows. First, the probability of a political crisis in equilibrium increases with the scope of the political principal-agent problem. Second, political uncertainty enlarges the set of parameters for which a banking crisis takes place and thereby increases financial instability. Third, politico-financial crises may stem from foreign lenders' loss of confidence.