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Bailouts and Financial Fragility

  • Todd Keister

    ()

    (Rutgers University)

Should policy makers be prevented from bailing out investors in the event of a crisis? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the policy maker will respond by using 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: while it induces intermediaries to become more liquid, it may nevertheless lower welfare and leave the economy more susceptible to a crisis. A policy of taxing short-term liabilities, in contrast, can both improve the allocation of resources and promote financial stability.

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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201401.

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Length: 20 pages
Date of creation: 29 Jan 2014
Date of revision:
Handle: RePEc:rut:rutres:201401
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