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Bailouts and Financial Fragility

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  • Todd Keister

    (Rutgers University)

Abstract

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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  • Todd Keister, 2014. "Bailouts and Financial Fragility," Departmental Working Papers 201401, Rutgers University, Department of Economics.
    • Handle: RePEc:rut:rutres:201401
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    More about this item

    Keywords

    bank runs; bailouts; moral hazard; financial regulation;
    All these keywords.

    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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