Essays on Financial Crisis and Bailout

This dissertation consists of three essays on financial economics. 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. The value of the asset is the firm's private information, which results in inefficient trading of the asset due to standard adverse selection. Although the adverse selection problem creates a scope for government intervention, accepting a bailout can signal the toxicity of the asset, which worsens the adverse selection for the firm in the subsequent trading of its asset. We find multiple equilibrium responses to a government bailout. Bailout terms that would otherwise be acceptable may be refused due to the stigma. Even terms that are so generous as to be acceptable for firms with non-toxic assets may result in low take-up; nevertheless, such a policy could be beneficial indirectly by allowing a firm to improve its market perception by refusing the bailout. Bailout that leads to immediate market rejuvenation is welfare-dominated by an equilibrium without such market rejuvenation. We further explore an optimal design of a bailout program both in offer terms and formats and show that a secret bailout that conceals the identity of its recipient can mitigate the stigma and can implement the (constrained) efficient outcome.;The second chapter is motivated by a situation in which when a firm is financially distressed, it is uncertain whether the distress stems from an unfolding economic crisis or excessive risk-taking by the firm. 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. 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. 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. 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. Therefore, the government takes an alarmist stance, bailing out more frequently than it would without the long-term consideration.;The third chapter analyzes how the government's strategic disclosure of its superior information on an aggregate uncertainty influences risk taking by a firm. The government is often tempted to strategically disclose its superior knowledge to influence management of financial risk by a firm. To capture this, I develop a static model in which the government with private information sends a cheap-talk message to the firm before assuming its risk taking. 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. However, the firm rationally infers this strategic disclosure, and therefore, may assume excessive risk taking no matter what messages does it receive from the government. Consequently, an informative equilibrium may worsen moral hazard compared to the babbling equilibrium.