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Government guarantees and financial stability

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  • Allen, Franklin
  • Carletti, Elena
  • Goldstein, Itay
  • Leonello, Agnese

Abstract

Banks are intrinsically fragile because of their role as liquidity providers. This results in under-provision of liquidity. We analyze the effect of government guarantees on the interconnection between banks' liquidity creation and likelihood of runs in a global-game model, where banks' and depositors' behavior are endogenous and affected by the amount and form of guarantee. The main insight of our analysis is that guarantees are welfare improving because they induce banks to improve liquidity provision, although that sometimes increases the likelihood of runs or creates distortions in banks' behavior.

Suggested Citation

  • Allen, Franklin & Carletti, Elena & Goldstein, Itay & Leonello, Agnese, 2018. "Government guarantees and financial stability," Journal of Economic Theory, Elsevier, vol. 177(C), pages 518-557.
  • Handle: RePEc:eee:jetheo:v:177:y:2018:i:c:p:518-557
    DOI: 10.1016/j.jet.2018.06.007
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    More about this item

    Keywords

    Panic runs; Fundamental runs; Government guarantees; Bank moral hazard;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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