Government Intervention in Response to the Subprime Financial Crisis: The Good into the Pot, the Bad into the Crop

32 Pages Posted: 29 Jan 2009 Last revised: 5 May 2010

Date Written: February 5, 2009

Abstract

The recent global financial crisis represents a major economic challenge. In order to prevent such market failure, it is vital to understand what caused the crisis and what are the lessons to be learned. Given the tremendous bailout packages worldwide, we discuss the role of governments as lenders of last resort. In our view, it is important not to suspend the market mechanism of bankruptcy via granting rescue packages. Only those institutions which are illiquid but solvent should be rescued, and this should occur at a significant cost for the respective institution. We provide a formal illustration of a rescue mechanism, which allows to distinguish between illiquid but solvent and insolvent banks. Furthermore, we argue that stricter regulation cannot be the sole consequence of the crisis. There appears to be a need for improved risk awareness, more sophisticated risk management and an alignment of interest among the participants in the market for credit risk.

Keywords: financial crisis, government intervention, bailout, risk management, credit risk, credit derivatives, securitization

JEL Classification: G28

Suggested Citation

Breitenfellner, Bastian and Wagner, Niklas F., Government Intervention in Response to the Subprime Financial Crisis: The Good into the Pot, the Bad into the Crop (February 5, 2009). Available at SSRN: https://ssrn.com/abstract=1334804 or http://dx.doi.org/10.2139/ssrn.1334804

Bastian Breitenfellner

Passau University ( email )

Innstrasse 27
Passau, 94032
Germany

HOME PAGE: http://www.wiwi.uni-passau.de/index.php?id=2285&L=2

Niklas F. Wagner (Contact Author)

Passau University ( email )

Innstrasse 27
Passau, 94030
Germany

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