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Bailouts and financial fragility

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  • Todd Keister

Abstract

How does the belief that policymakers will bail out investors in the event of a crisis affect the allocation of resources and the stability of the financial system? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the efficient policy response is to use public resources to augment the private consumption of those investors facing losses. The anticipation of such a “bailout” distorts ex ante incentives, leading intermediaries to choose arrangements with excessive illiquidity and thereby increasing financial fragility. Prohibiting bailouts is not necessarily desirable, however: it induces intermediaries to become too liquid from a social point of view and may, in addition, leave the economy more susceptible to a crisis. A policy of taxing short-term liabilities, in contrast, can correct the incentive problem while improving financial stability.

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  • Todd Keister, 2010. "Bailouts and financial fragility," Staff Reports 473, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:473
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    More about this item

    Keywords

    Intermediation (Finance) ; Financial crises ; Liquidity (Economics) ; Taxation ; Business failures;

    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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