Financial Firm Resolution Policy as a Time-Consistency Problem

20 Pages Posted: 19 Dec 2012

See all articles by Borys Grochulski

Borys Grochulski

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: April 1, 2011

Abstract

In this article, we describe a time-consistency problem that can arise in the government's policy toward insolvent financial firms. We present this problem using a simple model in which shareholders of a large financial firm can raise low-cost debt financing and take on an excessive amount of risk. If this risk backfires, there are spillover effects harmful to the economy as a whole. In such a crisis event, the government's best action is to bail the firm out. The prospect of this bailout is the very reason why the firm can raise debt at low cost while taking on excessive risk. Given the structure of this problem, we discuss government policy that can eliminate or mitigate excessive risk-taking. Efficient resolution policy can eliminate excessive risk-taking only if it can completely eliminate the negative spillover effect. Alternatively, excessive risk-taking can be eliminated either directly by accurate government supervision of system-wide risk-taking, or indirectly by imposing binding capital requirements.

Suggested Citation

Grochulski, Borys, Financial Firm Resolution Policy as a Time-Consistency Problem (April 1, 2011). FRB Richmond Economic Quarterly, vol. 97, no. 2, Second Quarter 2011, pp. 133-152, Available at SSRN: https://ssrn.com/abstract=2190599

Borys Grochulski (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

HOME PAGE: http://www.richmondfed.org/research/economists/bios/grochulski_bio.cfm

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