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Expectations versus fundamentals: does the cause of banking panics matter for prudential policy?

  • Todd Keister
  • Vijay Narasiman

There is a longstanding debate about whether banking panics and other financial crises always have fundamental causes or are sometimes the result of self-fulfilling beliefs. Disagreement on this point would seem to present a serious obstacle to designing policies that promote financial stability. However, we show that the appropriate choice of policy is invariant to the underlying cause of banking panics in some situations. In our model, the anticipation of being bailed out in the event of a crisis distorts the incentives of financial institutions and their investors. Two policies that aim to correct this distortion are compared: restricting policymakers from engaging in bailouts, and allowing bailouts but taxing the short-term liabilities of financial institutions. We find that the latter policy yields higher equilibrium welfare regardless of whether panics are sometimes caused by self-fulfilling beliefs.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 519.

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Date of creation: 2011
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Handle: RePEc:fip:fednsr:519
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  1. Todd Keister, 2010. "Bailouts and financial fragility," Staff Reports 473, Federal Reserve Bank of New York.
  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. Huberto M. Ennis & Todd Keister, 2007. "Bank runs and institutions : the perils of intervention," Working Paper 07-02, Federal Reserve Bank of Richmond.
  4. Edward J. Green & Ping Lin, 1996. "Implementing efficient allocations in a model of financial intermediation," Working Papers 576, Federal Reserve Bank of Minneapolis.
  5. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
  6. Huberto M. Ennis, 2003. "Economic fundamentals and bank runs," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 55-71.
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