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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 ag-gregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.

Suggested Citation

  • V. V. Chari & Patrick J. Kehoe, 2013. "Bailouts, time inconsistency, and optimal regulation," Staff Report 481, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:481
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    Cited by:

    1. Mr. Thierry Tressel & Mr. Thierry Verdier, 2014. "Optimal Prudential Regulation of Banks and the Political Economy of Supervision," IMF Working Papers 2014/090, International Monetary Fund.
    2. Emmanuel Farhi & Jean Tirole, 2012. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February.
    3. Ricardo Reis, 2013. "Central Bank Design," Journal of Economic Perspectives, American Economic Association, vol. 27(4), pages 17-44, Fall.
    4. Kartik B. Athreya, 2015. "Systemic Risk and the Pursuit of Efficiency," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 23-47.
    5. Ernesto Pastén, 2014. "Bailouts and Prudential Policies - A Delicate Interaction," Working Papers Central Bank of Chile 743, Central Bank of Chile.
    6. 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.
    7. Marius A. Zoican & Lucyna A. Górnicka, 2013. "Banking Unions: Distorted Incentives and Efficient Bank Resolution," Tinbergen Institute Discussion Papers 13-184/VI, Tinbergen Institute, revised 16 May 2014.
    8. Sebastian Di Tella, 2017. "Optimal Regulation of Financial Intermediaries," NBER Working Papers 23586, National Bureau of Economic Research, Inc.
    9. Augusto de la Torre & Alain Ize, 2016. "The Conceptual Foundations of Macroprudential Policy: A Roadmap," International Finance, Wiley Blackwell, vol. 19(3), pages 333-352, December.
    10. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
    11. Emmanuel Farhi & Jean Tirole, 2018. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," Review of Economic Studies, Oxford University Press, vol. 85(3), pages 1781-1823.
    12. Jin Cheng & Meixing Dai & Frédéric Dufourt, 2016. "Banking Crisis, Moral Hazard and Fiscal Policy Responses," Working Papers of BETA 2016-06, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.
    13. Claudio Oliveira De Moraes & Helder Ferreira de Mendonça, 2017. "The bridge between macro and micro banking regulation: A framework from the model of financial flows," Journal of Economic Studies, Emerald Group Publishing, vol. 44(2), pages 214-225, May.
    14. Thomas J. Carter, 2017. "Optimal Interbank Regulation," Staff Working Papers 17-48, Bank of Canada.
    15. Juliane Begenau, 2015. "Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model," 2015 Meeting Papers 687, Society for Economic Dynamics.

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    More about this item

    Keywords

    Regulation;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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