Bailouts and financial fragility

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30 Scopus citations

Abstract

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.

Original languageEnglish (US)
Article numberrdv044
Pages (from-to)704-736
Number of pages33
JournalReview of Economic Studies
Volume83
Issue number2
DOIs
StatePublished - Apr 1 2016

ASJC Scopus subject areas

  • Economics and Econometrics

Keywords

  • Bailouts
  • Bank runs
  • Financial regulation
  • Moral hazard

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