The paper elicits a mechanism by which private leverage choices exhibit strategic complementarities through the reaction of monetary policy. When everyone engages in maturity transformation, authorities have little choice but facilitating refinancing. In turn, refusing to adopt a risky balance sheet lowers the return on equity. The key ingredient is that monetary policy is non-targeted. The ex post benefits from a monetary bailout accrue in proportion to the number amount of leverage, while the distortion costs are to a large extent fixed. This insight has important consequences. First, banks choose to correlate their risk exposures. Second, private borrowers may deliberately choose to increase their interest-rate sensitivity following bad news about future needs for liquidity. Third, optimal monetary policy is time inconsistent. Fourth, there is a role for macro-prudential supervision. We characterize the optimal regulation, which takes the form of a minimum liquidity requirement coupled with monitoring of the quality of liquid assets. We establish the robustness of our insights when the set of bailout instruments is endogenous and characterize the structure of optimal bailouts.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
15138.
Length: Date of creation: Jul 2009 Date of revision: Handle: RePEc:nbr:nberwo:15138
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Find related papers by JEL classification: E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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Romain Ranciere & Aaron Tornell & Frank Westermann, 2005.
"Systemic Crises and Growth,"
NBER Working Papers
11076, National Bureau of Economic Research, Inc.
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Romain Rancière & Aaron Tornell & Frank Westermann, 2002.
"Systemic Crises and Growth,"
Economics Working Papers
854, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2004.
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