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Financial firm resolution policy as a time-consistency problem

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  • Borys Grochulski
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    Abstract

    In this article, we describe a time-consistency problem that can arise in the government's policy toward insolvent financial firms. We present this problem using a simple model in which shareholders of a large financial firm can raise low-cost debt financing and take on an excessive amount of risk. If this risk backfires, there are spillover effects harmful to the economy as a whole. In such a crisis event, the government's best action is to bail the firm out. The prospect of this bailout is the very reason why the firm can raise debt at low cost while taking on excessive risk. Given the structure of this problem, we discuss government policy that can eliminate or mitigate excessive risk-taking. Efficient resolution policy can eliminate excessive risk-taking only if it can completely eliminate the negative spillover effect. Alternatively, excessive risk-taking can be eliminated either directly by accurate government supervision of system-wide risk-taking, or indirectly by imposing binding capital requirements.

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    File URL: http://www.richmondfed.org/publications/research/economic_quarterly/2011/q2/pdf/grochulski.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

    Volume (Year): (2011)
    Issue (Month): 2Q ()
    Pages: 133-152

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    Handle: RePEc:fip:fedreq:y:2011:i:2q:p:133-152:n:v.97no.2

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    Keywords: Financial markets;

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    1. David A. Marshall & Edward S. Prescott, 2000. "Bank capital regulation with and without state-contingent penalties," Working Paper Series WP-00-10, Federal Reserve Bank of Chicago.
    2. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
    3. Cochrane, John H, 1995. "Time-Consistent Health Insurance," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 445-73, June.
    4. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    5. David A. Marshall & Edward Simpson Prescott, 2004. "State-Contingent Bank Regulation With Unobserved Actionas And Unobserved Characteristics," Working Papers wp2004_0407, CEMFI.
    6. Arantxa Jarque & Edward S. Prescott, 2010. "Optimal bonuses and deferred pay for bank employees : implications of hidden actions with persistent effects in time," Working Paper 10-16, Federal Reserve Bank of Richmond.
    7. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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