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Banking Crisis, Moral Hazard and Fiscal Policy Responses

Listed author(s):
  • Jin Cheng
  • Meixing Dai
  • Frédéric Dufourt

This paper examines the role of fiscal policy as prudential instrument in preventing banking crisis in a framework where the government faces the tradeoff between the supply of public services and the stabilization of the banking system. We advocate that in a monetary union, the national governments without monetary autonomy should redesign their fiscal policy to prevent financial crises due to the moral hazard of banking entrepreneurs whose incentives are distorted by their expectations of ex-post bailout. We show that the government has incentive to bail out banks under both discretion and commitment if the banking sector is relatively influential. To prevent financial fragility, the pre-committed fiscal bailout policy should be time-consistent and incite banks to keep sufficient liquidity reserves and a low leverage ratio. Such policy could be efficiently complemented by public lending with a pre-announced interest rate that reduces banks’ moral hazard incentives but not their normal risk-taking.

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File URL: http://www.beta-umr7522.fr/productions/publications/2016/2016-06.pdf
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Paper provided by Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg in its series Working Papers of BETA with number 2016-06.

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Date of creation: 2016
Handle: RePEc:ulp:sbbeta:2016-06
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  1. Patrick Bolton & Olivier Jeanne, 2011. "Sovereign Default Risk and Bank Fragility in Financially Integrated Economies," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(2), pages 162-194, June.
  2. Hasman, Augusto & López, Ángel L. & SamartIín, Margarita, 2011. "Government, taxes and banking crises," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2761-2770, October.
  3. Hryckiewicz, Aneta, 2014. "What do we know about the impact of government interventions in the banking sector? An assessment of various bailout programs on bank behavior," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 246-265.
  4. Kollmann, Robert & Ratto, Marco & Roeger, Werner & in′t Veld, Jan, 2013. "Fiscal policy, banks and the financial crisis," Journal of Economic Dynamics and Control, Elsevier, vol. 37(2), pages 387-403.
  5. Chiorazzo, Vincenzo & Milani, Carlo, 2011. "The impact of taxation on bank profits: Evidence from EU banks," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3202-3212.
  6. Patrick Kehoe & V.V. Chari, 2010. "Bailouts, Time Inconsistency, and Optimal Regulation," 2010 Meeting Papers 527, Society for Economic Dynamics.
  7. Sebastian Dellepiane Avellaneda & Niamh Hardiman, 2010. "The European Context of Ireland’s Economic Crisis," The Economic and Social Review, Economic and Social Studies, vol. 41(4), pages 473-500.
  8. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  9. Goodhart, Charles, 2011. "The emerging new architecture of financial regulation," CFS Working Paper Series 2011/12, Center for Financial Studies (CFS).
  10. Masciandaro, Donato & Passarelli, Francesco, 2013. "Financial systemic risk: Taxation or regulation?," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 587-596.
  11. Corsetti, Giancarlo & Guimaraes, Bernardo & Roubini, Nouriel, 2006. "International lending of last resort and moral hazard: A model of IMF's catalytic finance," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 441-471, April.
  12. Allen, Franklin & Carletti, Elena & Gale, Douglas, 2009. "Interbank market liquidity and central bank intervention," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 639-652, July.
  13. Roberto Chang & Andres Velasco, 2001. "A Model of Financial Crises in Emerging Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 116(2), pages 489-517.
  14. Philip R. Lane, 2012. "The European Sovereign Debt Crisis," Journal of Economic Perspectives, American Economic Association, vol. 26(3), pages 49-68, Summer.
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