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Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?

Author

Listed:
  • Todd Keister

    (Rutgers University)

  • Vijay Narasiman

    (Harvard University)

Abstract

Should policy makers be permitted to intervene during a financial crisis by bailing out financial institutions and their investors? We study this question in a model that incorporates two competing views about the underlying causes of these crises: self-fulfilling shifts in investors' expectations and deteriorating economic fundamentals. We show that - in both cases - the desirability of allowing intervention depends on a tradeoff between incentives and insurance. If policy makers can correct incentive distortions through effective regulation and supervision, then allowing intervention is always optimal. If regulation is imperfect and the risk-sharing benefit from intervention is absent, in contrast, it is optimal to prohibit intervention. Our results show that, in some cases, it is possible to provide meaningful policy analysis without taking a stand on the contentious issue of whether financial crises are driven by expectations or fundamentals. (Copyright: Elsevier)

Suggested Citation

  • Todd Keister & Vijay Narasiman, 2016. "Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 89-104, July.
  • Handle: RePEc:red:issued:13-73
    DOI: 10.1016/j.red.2015.03.004
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    References listed on IDEAS

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    Cited by:

    1. Andolfatto, David & Nosal, Ed, 2017. "Bank Panics and Scale Economies," Working Papers 2017-9, Federal Reserve Bank of St. Louis.
    2. Allen, Franklin & Carletti, Elena & Goldstein, Itay & Leonello, Agnese, 2015. "Government Guarantees and Financial Stability," CEPR Discussion Papers 10560, C.E.P.R. Discussion Papers.
    3. Huberto Ennis & Todd Keister, 2016. "Optimal banking contracts and financial fragility," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 61(2), pages 335-363, February.
    4. Roberto Robatto, 2018. "Flight to Liquidity and Systemic Bank Runs," 2018 Meeting Papers 276, Society for Economic Dynamics.
    5. Fernando Martin & Aleksander Berentsen & David Andolfatto, 2016. "Financial Fragility in Monetary Economies," 2016 Meeting Papers 1626, Society for Economic Dynamics.

    More about this item

    Keywords

    Bank runs; Bailouts; Financial stability; Moral hazard; Macroprudential regulation;

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • 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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