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Bailouts, Time Inconsistency, and Optimal Regulation

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  • V.V. Chari
  • Patrick J. Kehoe

Abstract

We develop a model in which, in order to provide managerial incentives, it is optimal to have costly bankruptcy. If benevolent governments can commit to their policies, it is optimal not to interfere with private contracts. Such policies are time inconsistent in the sense that, without commitment, governments have incentives to bail out firms by buying up the debt of distressed firms and renegotiating their contracts with managers. From an ex ante perspective, however, such bailouts are costly because they worsen incentives and thereby reduce welfare. We show that regulation in the form of limits on the debt-to-value ratio of firms mitigates the time-inconsistency problem by eliminating the incentives of governments to undertake bailouts. In terms of the cyclical properties of regulation, we show that regulation should be tightest in aggregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19192.

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Date of creation: Jun 2013
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Handle: RePEc:nbr:nberwo:19192

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  1. Gertler, Mark & Kiyotaki, Nobuhiro & Queralto, Albert, 2012. "Financial crises, bank risk exposure and government financial policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 59(S), pages S17-S34.
  2. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2008. "A Theory of Liquidity and Regulation of Financial Intermediation," Levine's Working Paper Archive 122247000000002006, David K. Levine.
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  5. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers, Bank of England 319, Bank of England.
  6. Jean Tirole & Emmanuel Farhi, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," Working Papers, Fondazione Eni Enrico Mattei 2009.57, Fondazione Eni Enrico Mattei.
  7. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 16270, University Library of Munich, Germany.
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  9. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, American Economic Association, vol. 78(4), pages 647-61, September.
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  13. Abreu, Dilip, 1988. "On the Theory of Infinitely Repeated Games with Discounting," Econometrica, Econometric Society, Econometric Society, vol. 56(2), pages 383-96, March.
  14. Mailath George J. & Mester Loretta J., 1994. "A Positive Analysis of Bank Closure," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 3(3), pages 272-299, June.
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Cited by:
  1. Thierry Tressel & Thierry Verdier, 2014. "Optimal Prudential Regulation of Banks and the Political Economy of Supervision," IMF Working Papers 14/90, International Monetary Fund.
  2. Farhi, Emmanuel & Tirole, Jean, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," TSE Working Papers, Toulouse School of Economics (TSE) 09-052, Toulouse School of Economics (TSE), revised Oct 2010.
  3. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
  4. Ricardo Reis, 2013. "Central Bank Design," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 27(4), pages 17-44, Fall.
  5. Gertler, Mark & Kiyotaki, Nobuhiro & Queralto, Albert, 2012. "Financial crises, bank risk exposure and government financial policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 59(S), pages S17-S34.
  6. Marius A. Zoican & Lucyna A. Górnycka, 2013. "Banking Unions: Distorted Incentives and Efficient Bank Resolution," Tinbergen Institute Discussion Papers 13-184/VI, Tinbergen Institute.
  7. de la Torre, Augusto & Ize, Alain, 2013. "The rhyme and reason for macroprudential policy : four guideposts to find your bearings," Policy Research Working Paper Series 6576, The World Bank.

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