This paper studies the role of bailout expectations in shaping the dynamics of bank credit spreads and the implications for bank risk-taking behavior.

I propose a dynamic model of financial intermediation with bank default and time-varying bailout probabilities.

Credit spreads are driven by both fundamental risk and bailout expectations.

These two forces have contrasting implications for the joint comovement of credit spreads and default probabilities.

Combining the model with US bank credit default swap spreads and option-implied default probabilities,

I indirectly infer the relative importance of fundamentals and bailout expectations as drivers of spreads.

I find that 28 basis points out of the 34-basis-point rise in credit spreads after 2010 are due to lower perceived bailout probabilities, and that the remainder reflects weaker fundamentals and is partly offset by tighter capital requirements.

Finally, I use the model to measure the effect of lower bailout expectations and tighter regulation on the expected returns of bank assets and the cost of bank credit.

Abstracting from lower bailout expectations overstates the importance of regulatory tightening by a factor of two.