Bailouts and financial fragility

Todd Keister

No 473, Staff Reports from Federal Reserve Bank of New York

Abstract: How does the belief that policymakers will bail out investors in the event of a crisis affect the allocation of resources and the stability of the financial system? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the efficient policy response is to use public resources to augment the private consumption of those investors facing losses. The anticipation of such a ?bailout? distorts ex ante incentives, leading intermediaries to choose arrangements with excessive illiquidity and thereby increasing financial fragility. Prohibiting bailouts is not necessarily desirable, however: it induces intermediaries to become too liquid from a social point of view and may, in addition, leave the economy more susceptible to a crisis. A policy of taxing short-term liabilities, in contrast, can correct the incentive problem while improving financial stability.

Keywords: Intermediation (Finance); Financial crises; Liquidity (Economics); Taxation; Business failures (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-ban
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Citations: View citations in EconPapers (15)

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Related works:
Journal Article: Bailouts and Financial Fragility (2016)
Working Paper: Bailouts and Financial Fragility (2014)
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