“Complementing Financial Discipline with Bailouts” by ZHOU Wen
University of Hong Kong
Chinese University of Hong Kong
When firms are interlinked by specific relations, financial discipline may invoke negative externality: the closure of one loss-making firm may lead to losses in an otherwise profitable firm. In such an environment, a commitment to financial discipline may destroy rather than improve incentives. Inspired by reform experiences in China, we model a dual track financial system with centralized financing for some firms and decentralized financing for others, and demonstrate a complementarity between bailouts and financial discipline: Bailout under centralized financing helps sustain financial discipline in decentralized financing and thus improves incentives. Further, the prospect of future financial discipline in decentralized financing improves incentives in centralized financing despite bailout. Our analysis sheds light on the experience of China's financial and real sector development and provides a useful benchmark for understanding bailouts in general in the current financial crisis.