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Staff Reports
Bailouts and Financial Fragility
2014 September 2010 Number 473
Revised July 2012
Revised July 2012
JEL classification: E61, G21, G28
Should policymakers 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 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 both improve the allocation of resources and promote financial stability.
Available only in PDF
40 pages / 531 kb
40 pages / 531 kbTools
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