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Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts

  • 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 Toulouse School of Economics (TSE) in its series TSE Working Papers with number 09-052.

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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:tse:wpaper:21951
Contact details of provider: Phone: (+33) 5 61 12 86 23
Web page: http://www.tse-fr.eu/

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  6. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
  7. Morris, Stephen & Shin, Hyun Song, 1997. "Unique Equilibrium in a Model of Self-fulfilling Currency Attacks," CEPR Discussion Papers 1687, C.E.P.R. Discussion Papers.
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  10. V.V. Chari & Patrick J. Kehoe, 2013. "Bailouts, Time Inconsistency, and Optimal Regulation," NBER Working Papers 19192, National Bureau of Economic Research, Inc.
  11. Martin Schneider & Aaron Tornell, 2004. "Balance Sheet Effects, Bailout Guarantees and Financial Crises," Review of Economic Studies, Wiley Blackwell, vol. 71, pages 883-913, 07.
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  15. 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.
  16. P. Diamond, 1980. "Aggregate Demand Management in Search Equilibrium," Working papers 268, Massachusetts Institute of Technology (MIT), Department of Economics.
  17. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  18. Huberto M. Ennis & Todd Keister, 2007. "Bank runs and institutions : the perils of intervention," Working Paper 07-02, Federal Reserve Bank of Richmond.
  19. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  20. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  21. 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.
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  24. Philippon, Thomas & Schnabl, Philipp, 2009. "Efficient Recapitalization," CEPR Discussion Papers 7516, C.E.P.R. Discussion Papers.
  25. 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.
  26. Ernesto Pastén, 2011. "Time - Consistent Bailout Plans," Working Papers Central Bank of Chile 635, Central Bank of Chile.
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