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Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts

Listed author(s):
  • Farhi, Emmanuel
  • Tirole, Jean

The paper elicits a mechanism by which private leverage choices exhibit strategic complementarities through the reaction of monetary policy. When everyone engages in maturity transformation, authorities haver little choice but facilitating refinancing. In turn, refusing to adopt a risky balance sheet lowers the return on equity. The key ingredient is that monetary policy is non-targeted. The ex post benefits from a monetary bailout accrue in proportion to the number amount of leverage, while the distortion costs are to a large extent fixed. This insight has important consequences. First, banks choose to correlate their risk exposures. Second, private borrowers may deliberately choose to increase their interest-rate sensitivity following bad news about future needs for liquidity. Third, optimal monetary policy is time inconsistent. Fourth, macro-prudential supervision is called for. We characterize the optimal regulation, which takes the form of a minimum liquidity requirement coupled with monitoring of the quality of liquid assets. We establish the robustness of our insights when the set of bailout instruments is endogenous and characterize the structure of optimal bailouts.

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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 571.

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Length: 49 pages
Date of creation: Jun 2009
Date of revision: Oct 2010
Publication status: Published in American Economic Review, vol. 102, février 2012, p. 60-93.
Handle: RePEc:ide:wpaper:20896
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  7. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  8. Holmström, Bengt, 2013. "Inside and Outside Liquidity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262518536, December.
  9. Jean Tirole & Emmanuel Farhi, 2010. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," 2010 Meeting Papers 822, Society for Economic Dynamics.
  10. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
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  15. Ernesto Pastén, 2011. "Time - Consistent Bailout Plans," Working Papers Central Bank of Chile 635, Central Bank of Chile.
  16. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  17. V. V. Chari & Patrick J. Kehoe, 2013. "Bailouts, time inconsistency, and optimal regulation," Staff Report 481, Federal Reserve Bank of Minneapolis.
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  19. Martin Schneider & Aaron Tornell, 2004. "Balance Sheet Effects, Bailout Guarantees and Financial Crises," Review of Economic Studies, Oxford University Press, vol. 71(3), pages 883-913.
  20. Kashyap, Anil K. & Rajan, Raghuram G. & Stein, Jeremy C., 2008. "Rethinking capital regulation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 431-471.
  21. 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.
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  23. 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.
  24. George J. Mailath & Loretta J. Mester, 1993. "A positive analysis of bank closure," Working Papers 93-10/R, Federal Reserve Bank of Philadelphia.
  25. Cooper,Russell, 1999. "Coordination Games," Cambridge Books, Cambridge University Press, number 9780521570176, May.
  26. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
  27. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  28. Russell Cooper & Andrew John, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, Oxford University Press, vol. 103(3), pages 441-463.
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