Abstract:
Financial institutions are increasingly linked internationally and engaged in cross-border
operations. As a result, financial crises and potential bail-outs by governments have important
international implications. Extending Allen and Gale (2000) we provide a model of
international contagion allowing for bank bail-outs financed by distortionary taxes. In the
sequential game between governments, there are inefficiencies due to spillovers, free-riding
and limited burden-sharing. When countries are of equal size, an increase in cross-border
deposit holdings improves, in general, the non-cooperative outcome. For efficient crisis managment,
ex-ante fiscal burden sharing is essential as ex-post contracts between governments
do not achieve the same global welfare.
