Banking Crisis, Moral Hazard and Fiscal Policy Responses

This paper examines the role of fiscal policy as prudential instrument in preventing banking crisis in a framework where the government faces the tradeoff between the supply of public services and the stabilization of the banking system. We advocate that in a monetary union, the national governments without monetary autonomy should redesign their fiscal policy to prevent financial crises due to the moral hazard of banking entrepreneurs whose incentives are distorted by their expectations of ex-post bailout. We show that the government has incentive to bail out banks under both discretion and commitment if the banking sector is relatively influential. To prevent financial fragility, the pre-committed fiscal bailout policy should be time-consistent and incite banks to keep sufficient liquidity reserves and a low leverage ratio. Such policy could be efficiently complemented by public lending with a pre-announced interest rate that reduces banks’ moral hazard incentives but not their normal risk-taking.