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Financial firm resolution policy as a time-consistency problem

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  • Borys Grochulski

Abstract

In this article, we describe a time-consistency problem that can arise in the government's policy toward insolvent financial firms. We present this problem using a simple model in which shareholders of a large financial firm can raise low-cost debt financing and take on an excessive amount of risk. If this risk backfires, there are spillover effects harmful to the economy as a whole. In such a crisis event, the government's best action is to bail the firm out. The prospect of this bailout is the very reason why the firm can raise debt at low cost while taking on excessive risk. Given the structure of this problem, we discuss government policy that can eliminate or mitigate excessive risk-taking. Efficient resolution policy can eliminate excessive risk-taking only if it can completely eliminate the negative spillover effect. Alternatively, excessive risk-taking can be eliminated either directly by accurate government supervision of system-wide risk-taking, or indirectly by imposing binding capital requirements.

Suggested Citation

  • Borys Grochulski, 2011. "Financial firm resolution policy as a time-consistency problem," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 133-152.
  • Handle: RePEc:fip:fedreq:y:2011:i:2q:p:133-152:n:v.97no.2
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    References listed on IDEAS

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    1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    2. Robert G. King & Alexander L. Wolman, 2004. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 119(4), pages 1513-1553.
    3. Marshall, David A. & Prescott, Edward Simpson, 2006. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2015-2049, November.
    4. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 343, European Central Bank.
    5. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
    6. Marshall, David A. & Prescott, Edward Simpson, 2001. "Bank capital regulation with and without state-contingent penalties," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 139-184, June.
    7. Cochrane, John H, 1995. "Time-Consistent Health Insurance," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 445-473, June.
    8. Arantxa Jarque & Edward Simpson Prescott, 2010. "Optimal bonuses and deferred pay for bank employees : implications of hidden actions with persistent effects in time," Working Paper 10-16, Federal Reserve Bank of Richmond.
    9. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
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    Cited by:

    1. Jarque, Arantxa & Price, David A., 2015. "Living Wills: A Tool for Curbing Too Big to Fail," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 77-94.
    2. Athreya, Kartik B. & Jarque, Arantxa, 2015. "Understanding Living Wills," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 193-223.

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    Keywords

    Financial markets;

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