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Excessive Lending, Leverage, and Risk-Taking in the Presence of Bailout Expectations

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  • Andréas Georgiou
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    Abstract

    The financial crisis that began in 2007 has brought to the fore the issues of excesses in lending, leverage, and risk-taking as some of the fundamental causes of this crisis. At the same time, in dealing with the financial crisis there have been large scale interventions by governments, often referred to as bailouts of the lenders. This paper presents a framework where rational economic agents engage in ex ante excessive lending, borrowing, and risk-taking if creditors assign a positive probability to being bailed out. The paper also offers some thoughts on policy implications. It argues that it would be most productive for the long run if lending institutions were not bailed out. If the continuing existence of an institution was deemed essential, assistance should take the form of capital injections that dilute the equity of existing owners.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 09/233.

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    Length: 25
    Date of creation: 01 Oct 2009
    Date of revision:
    Handle: RePEc:imf:imfwpa:09/233

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    Related research

    Keywords: Moral hazard; Banking sector; Borrowing; Economic models; Financial risk; Intervention; Nonbank financial sector; probability; excessive lending; expected value; probability distribution; equation; investors; excessive risk; random variable; credit markets; probability distributions; investment loans; ownership structure; statistics; equations; optimization; rate of return;

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    1. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, Elsevier, vol. 2(3), pages 225-243, September.
    2. Jaffee, Dwight M & Modigliani, Franco, 1969. "A Theory and Test of Credit Rationing," American Economic Review, American Economic Association, American Economic Association, vol. 59(5), pages 850-72, December.
    3. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 90(4), pages 651-66, November.
    4. Gerhard Clemenz & Mona Ritthaler, 1992. "Credit markets with asymmetric information : a survey," Finnish Economic Papers, Finnish Economic Association, Finnish Economic Association, vol. 5(1), pages 12-26, Spring.
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