Bailouts and Financial Fragility

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 with fiscal transfers that partially cover intermediaries' losses. The anticipation of this bailout distorts ex ante incentives, leading intermediaries to become excessively illiquid and 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.Forthcoming in the Review of Economic Studies. I am grateful to participants at numerous conference and seminar presentations and especially to

Unprecedented Actions

“…Federal Reserve monetary policy actions during this period were therefore purely discretionary because they helped contribute to the belief in the "Greenspan put", a form of moral hazard in which financial institutions expect monetary policy to help them recover from bad investments (e.g., see Tirole andFarhi, 2009, andKeister, 2010). The failure of the Greenspan put to constrain moral hazard is one factor that has been cited as playing a role in the excessive risk taking that helped lead to the global financial crisis from 2007 to 2009.…”

Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission

“…We identify monetary policy as changes in central bank exogenous liquidity supply L. 11 Note that in this setup the central bank can create resources at t = 0 which are then invested by borrowers and produce output at t = 2. As in Allen et al (2014) and Keister (2014), we assume that monetary stimulus at t = 0 has costs at t = 2 given by c(L) which is increasing in L to ensure that monetary policy is not a "free lunch".…”

Optimal Bank Regulation in the Presence of Credit and Run Risk

“…In the Diamond-Dybvig model panics are a multiple equilibrium outcome. Cooper and Ross (1998), Peck and Shell (2003) and Keister (2015) suppose instead that the probability of a bank-run is driven by sunspots. In our earlier working paper Kashyap, Tsomocos and Vardoulakis (2014), in Gertler and Kiyotaki (2015) and in Choi, Eisenbach and Yorulmazer (2016) the probability of a run is determined by an exogenous function of key fundamentals.…”

“…The banker is willing to intermediate funds between savers and entrepreneurs if the utility she 11 See also Keister (2015) for a model with flexible deposit contracts, i.e., the payment that a depositor receives is determined by the bank as a best response to realized withdrawals in the intermediate period. Runs in his framework are partial in the sense that the bank can alter payments to stop withdrawals by patient depositors and avoid liquidation once the run state is revealed.…”

“…In the same token, we do not study emergency liquidity assistance from a Lender of Last Resort (Rochet and Vives, 2004) or suspension of convertibility (Ennis and Keister, 2009), which would also require non-trivial modifications in the model we present. See also Keister (2015) for an analysis of efficient bailouts, which should be complemented with prudential regulation. We believe that these are important avenues for future research in models that feature an elaborate banking sector subject to both credit and run risk like ours.…”