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Incentive Conflict In Central-Bank Responses to Sectoral Turmoil in Financial Hub Countries

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  • Edward J. Kane

Abstract

National safety nets are imbedded in country-specific regulatory cultures that encompass contradictory goals of nationalistic welfare maximization, merciful treatment of distressed institutions, and bureaucratic blame avoidance. Focusing on this goal conflict, this paper develops two hypotheses. First, in times of financial-sector stress, political pressure is bound to increase the incentive force of the second and third goals at the expense of the first. Second, gaps and distortions in cross-country connections between national safety nets require improvisational responses from de facto hegemonic regulators. Reinforced by reputational concerns, the hegemons' goal conflicts dispose them to react to cross-country evidence of incipient financial-institution insolvencies in short-sighted ways. During the commercial-paper and interbank turmoil of summer 2007, de facto hegemons used repurchase agreements to transfer taxpayer funds -- implicitly but in large measure -- to several of the particular institutions whose imprudence in originating, pricing, and securitizing poorly underwritten loans led to the turmoil in the first place. The precedent established by these transfers promises to exacerbate the depth, breadth, and duration of future instances of financial-institution insolvency by confirming that institutions that underinvest in due diligence can expect taxpayers to protect them from much of the adverse consequences.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13593.

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Date of creation: Nov 2007
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Handle: RePEc:nbr:nberwo:13593

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  1. La Porta, Rafael & Lopez-de-Silanes, Florencio & Shleifer, Andrei & Vishny, Robert W., 1998. "Law and Finance," Scholarly Articles 3451310, Harvard University Department of Economics.
  2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  3. Robert A. Eisenbeis & George G. Kaufman, 2005. "Bank crisis resolution and foreign-owned banks," Economic Review, Federal Reserve Bank of Atlanta, issue Q4, pages 1-18.
  4. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  5. Goodfriend, Marvin, 1994. "Why We Need an "Accord" for Federal Reserve Credit Policy: A Note," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(3), pages 572-80, August.
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Cited by:
  1. Philip Strahan, 2008. "Liquidity Production in 21st Century Banking," NBER Working Papers 13798, National Bureau of Economic Research, Inc.

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