Bailouts and Financial Fragility

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 by transferring resources to those investors facing losses. The anticipation of such a “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. I am grateful to participants at numerous conference and seminar presentations and especially to Giovanni Calice, Amil Dasgupta, Huberto Ennis, Yang Li, Antoine Martin, Alexander Monge-Naranjo, Robert Reed, Jaume Ventura and three anonymous referees for helpful comments. I also thank Vijay Narasiman and Parinitha Sastry for excellent research assistance. Parts of this work was completed while I was an economist at the Federal Reserve Bank of New York, a Fernand Braudel Fellow at the European University Institute, and a visiting scholar at the Stern School of Business, New York University; the hospitality and support of each of these institutions is gratefully acknowledged.