How does the belief that policy makers will bail out the financial system in the event of a crisis affect individual behavior and economic outcomes? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the efficient policy response is to partially “bail out” those investors facing losses, using public resources to augment their private consumption. The anticipation of such a bailout creates a moral hazard problem, however, and leads financial intermediaries to choose ex ante arrangements with excessive illiquidity. A policy that prohibits bailouts would encourage intermediaries to adopt more liquid positions, but may leave the economy more susceptible to self-fulfilling runs. A policy of taxing illiquidity, in contrast, can correct the moral hazard problem without increasing the scope for financial fragility.

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