Dueling policies:Why systemic risk taxation can fail

Two policy instruments for the banking sector are investigated, namely systemic risk taxation and constructive ambiguity about bailout policy. Bailout expectations can induce moral hazard in the form of excessive risk taking by banks. Systemic risk taxation induces banks to prefer uncorrelated investments, leading to lower systemic risk formation. Constructive ambiguity generates uncertainty about bailout prospects. However, systemic risk taxation also may inform banks about the regulator's concern for financial stability and thereby its bailout policy. This result leads to a trade-off between systemic risk taxation and constructive ambiguity and highlights the need to consider interdependence across policies when evaluating their effectiveness. (C) 2016 Elsevier B.V. All rights reserved.