This paper investigates the consequences of Chinese regulators deviating from a long-standing full bailout policy in addressing a city-level commercial bank’s distress. This event led to a persistent widening of credit spreads and a significant decline in funding ratios for negotiable certificates of deposit issued by small banks relative to large ones. Our empirical analysis pinpoints a novel contagion mechanism marked by diminished confidence in bank bailouts, which accounts for the subsequent collapse of several other small banks. However, the erosion of confidence in government guarantees enhances price efficiency and credit allocation while discouraging risk taking among small banks.