Banking Crises and the Government Policy Dilemma
Posted: 24 Oct 2012
Date Written: March 22, 2012
Abstract
Intervention has taken different forms in different countries and periods of time. Moreover, the high interconnection of financial institutions makes the (implicitly or explicitly) promise of no intervention made by governments barely credible. Moreover, it is largely claimed that these interventions will intensify the riskiness of banks' investments when they are considered too big to fail. In this paper we address the problem of resolving banking crises from the government perspective, taking into account the fact that preventing banking crises is crucial for the government. The main idea of this paper is that "no rescue" is a no credible policy option. Then, the government, when analyzing the best policy response, considers the "no rescue" option just as a benchmark. In addition, we introduce the moral hazard problem, inherent in the banking system, and consider the interaction between regulation, policy measures and banks' behaviour. This is the first paper that compares different policy plans to resolve banking crises in an environment where insufficiently capitalized banks have incentives to take risk.
Keywords: Banking crises, capital requirements, government intervention, moral hazard
JEL Classification: G21, G28
Suggested Citation: Suggested Citation