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The goal of this paper is to estimate a dynamic model of a bank to explain how bank bailouts exacerbate moral hazard. In the model, a bank makes an endogenous choice of the risks of its investments and can finance these investments by deposits and risky debt. I estimate nine model parameters that characterize a bank's behavior. For the full sample of U.S. banks, I estimate the expected bailout probability, conditional on bankruptcy, to be 52%. The estimated conditional bailout probabilities for small and large banks are 36% and 76%, respectively. The model predicts that rescue funding constitutes 4.2% of total assets, which is very close to the actual capital injection, 4.4% of total assets, made by the U.S. government under the 2008 Troubled Asset Relief Program (TARP). The simulation results show that a bank with a higher bailout belief takes more risks, especially when it is very close to bankruptcy.

Bank Bailouts and Moral Hazard? Evidence from Banks' Investment and Financing Decisions