Journal Article

Bailouts and Financial Fragility

Todd Keister

in The Review of Economic Studies

Volume 83, issue 2, pages 704-736
Published in print April 2016 | ISSN: 0034-6527
Published online October 2015 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1093/restud/rdv044
Bailouts and Financial Fragility

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  • Banking
  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • Financial Regulation

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Should policy makers be prevented from bailing out investors in the event of a crisis? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the policy maker will respond with fiscal transfers that partially cover intermediaries' losses. The anticipation of this bailout distorts ex ante incentives, leading intermediaries to become excessively illiquid and increasing financial fragility. Prohibiting bailouts is not necessarily desirable, however: while it induces intermediaries to become more liquid, it may nevertheless lower welfare and leave the economy more susceptible to a crisis. A policy of taxing short-term liabilities, in contrast, can both improve the allocation of resources and promote financial stability.

Keywords: Bank runs; Bailouts; Moral hazard; Financial regulation; G21; E61; G28

Journal Article.  16296 words.  Illustrated.

Subjects: Banking ; Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook ; Financial Regulation

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