L. Dam a,b, M. Koetter a,b

To test if safety nets create moral hazard in the banking industry, we develop a simultaneous structural equations model based on a game played by the regulator and banks. We estimate whether a higher probability of receiving capital injections increases risk taking. Using data collected by the German central bank regarding observed capital preservation measures and distressed exits by all German banks during the period 1994-2004, we find that an increase in the bailout probability of 1 % percent increases the probability of being in distress by 0.2 % on average. Most regulatory interventions, such as warnings and penalties, do not reduce moral haz-ard. Only interventions directly targeting bank management mitigate moral haz-ard