Beyond Pangloss: Financial sector origins of inefficient economic booms

Frederic Malherbe and Michael McMahon

Journal of Monetary Economics, 2024, vol. 145, issue C

Abstract: Government guarantees of bank liabilities have a long-standing history and are now ubiquitous. We study a model where financial sophistication enhances banks’ ability to exploit government guarantees and fuels inefficient economic booms. Driven by financial engineering, bank rent extraction creates a disconnect between lending decisions and borrower repayment prospects: In equilibrium, banks over-lend and only break-even courtesy of trading book profit. Exploitability is affected not only by financial sophistication but also by regulation. Given the pattern for regulatory changes in the last few decades, we posit that the Great Recession, partly, reversed a Great Distortion.

Keywords: Investment; Bank guarantees; Financial engineering (search for similar items in EconPapers)
JEL-codes: E22 G28 (search for similar items in EconPapers)
Date: 2024
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Citations: View citations in EconPapers (1)

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Working Paper: Beyond Pangloss: Financial sector origins of inefficient economic booms (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:moneco:v:145:y:2024:i:c:s0304393224000114

DOI: 10.1016/j.jmoneco.2024.103558

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