Bail-Outs and Financial Fragility

The Federal Reserve Bank of New York has released a staff report by Todd Keister titled Bailouts and Financial Fragility:

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.

I can’t help but think that the author – and perhaps the entire Fed and US political establishment – has lost his way a little:

The optimal response to this situation is to decrease public consumption and transfer resources to these investors – a “bailout.” The efficient bailout policy thus provides investors with (partial) insurance against the losses associated with a financial crisis.

In a decentralized setting, the anticipation of this type of bailout distorts the ex ante incentives of investors and their intermediaries. As a result, intermediaries choose to perform more maturity transformation, and hence become more illiquid, than in the benchmark allocation. This excessive illiquidity, in turn, implies that the financial system is more fragile in the sense that a self-fulfilling run can occur in equilibrium for a strictly larger set of parameter values. The incentive problem created by the anticipated bailout thus has two negative effects in this environment: it both distorts the allocation of resources in normal times and increases the financial system’s susceptibility to a crisis.

A policy of committing to no bailouts is not necessarily desirable, however. Such a policy would require intermediaries to completely self-insure against the possibility of a crisis, which would lead them to become more liquid (by performing less maturity transformation) than in the benchmark efficient allocation.

I am disturbed that the above does not distinguish between a bail-out (which would apply to insolvent institutions) and use of the discount window (which applies to illiquid institutions). It is becoming apparent that the Panic of 2007 was more of a liquidity crisis than a solvency crisis; but questions of solvency were exacerbated by regulatory requirements that minimum capital be kept on hand at all times (as has been said before, on at least one occasion by Willem Buiter, having a fixed capital requirement doesn’t really help in a crisis, because breaching that barrier means you’re bust, no matter what that fixed requirement might have been).

An optimal policy arrangement in the environment studied here requires permitting bailouts to occur, so that investors benefit from the efficient level of insurance, while offsetting the negative effects on ex ante incentives. One way this can be accomplished is by placing a Pigouvian tax on intermediaries’ short-term liabilities, which can also be interpreted as a tax on the activity of maturity transformation. In the simple environment studied here, the appropriate choice of tax rate will implement the benchmark efficient allocation and will decrease the scope for financial fragility relative to either the discretionary or the no-bailouts regime.

I would say that another way of accomplishing the same thing (albeit ex-post rather than ex-ante) would be to ensure that draws from the discount window are done at a penalty rate; but the opposite tack was taken during the crisis by providing the banks with sovereign guarantees for their debt.

One Response to “Bail-Outs and Financial Fragility”

  1. […] Panel on Economic Activity, Washington DC, 17 September 2010. In contrast to my complaint about the Bail Outs and Financial Fragility paper, he draws a clear distinction between “illiquid” and “insolvent”: But […]

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