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Title:Bailouts and financial fragility PDF Logo
Authors:Keister, Todd
Issue Date:2010
Series/Report no.:Staff Report, Federal Reserve Bank of New York 473
Abstract:How does the belief that policymakers will bail out investors in the event of a crisis affect the allocation of resources and the stability of the financial system? I study this question in a model of financial intermediation with limited commitment. When a crisis occurs, the efficient policy response is to use 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: it induces intermediaries to become too liquid from a social point of view and may, in addition, leave the economy more susceptible to a crisis. A policy of taxing short-term liabilities, in contrast, can correct the incentive problem while improving financial stability.
Subjects:Bank runs
financial regulation
JEL:E61
G21
G28
Document Type:Working Paper
Appears in Collections:Staff Reports, Federal Reserve Bank of New York

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