Banking Crisis, Moral Hazard and Fiscal Policy Responses

Jin Cheng, Meixing Dai () and Frédéric Dufourt

Working Papers of BETA from Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg

Abstract: This paper examines the role of fiscal policy as prudential instrument in preventing banking crisis in a framework where the government faces the tradeoff between the supply of public services and the stabilization of the banking system. We advocate that in a monetary union, the national governments without monetary autonomy should redesign their fiscal policy to prevent financial crises due to the moral hazard of banking entrepreneurs whose incentives are distorted by their expectations of ex-post bailout. We show that the government has incentive to bail out banks under both discretion and commitment if the banking sector is relatively influential. To prevent financial fragility, the pre-committed fiscal bailout policy should be time-consistent and incite banks to keep sufficient liquidity reserves and a low leverage ratio. Such policy could be efficiently complemented by public lending with a pre-announced interest rate that reduces banks’ moral hazard incentives but not their normal risk-taking.

Keywords: Banking crisis; capital ratio; over risk-taking; too big to fail; fiscal bailout; fiscal policy; government put; moral hazard; crisis resolution; public lending. (search for similar items in EconPapers)
JEL-codes: E44 G01 G11 G28 H21 H32 (search for similar items in EconPapers)
Date: 2016
New Economics Papers: this item is included in nep-ban, nep-cba and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:ulp:sbbeta:2016-06

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