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Bailouts and Financial Fragility

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  • Todd Keister

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.

Suggested Citation

  • Todd Keister, 2016. "Bailouts and Financial Fragility," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 83(2), pages 704-736.
    • Handle: RePEc:oup:restud:v:83:y:2016:i:2:p:704-736.
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    File URL: http://hdl.handle.net/10.1093/restud/rdv044
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    JEL classification:

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

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