The paper elicits a mechanism by which private leverage choices exhibit strategic complementarities through the reaction of monetary policy. When everyone engages in maturity transformation, authorities have little choice but facilitating refinancing. In turn, refusing to adopt a risky balance sheet lowers the return on equity. The key ingredient is that monetary policy is non-targeted. The ex post benefits from a monetary bailout accrue in proportion to the number amount of leverage, while the distortion costs are to a large extent fixed. This insight has important consequences. First, banks choose to correlate their risk exposures. Second, private borrowers may deliberately choose to increase their interest-rate sensitivity following bad news about future needs for liquidity. Third, optimal monetary policy is time inconsistent. Fourth, there is a role for macro-prudential supervision. We characterize the optimal regulation, which takes the form of a minimum liquidity requirement coupled with monitoring of the quality of liquid assets. We establish the robustness of our insights when the set of bailout instruments is endogenous and characterize the structure of optimal bailouts.
We thank Fernando Alvarez, Bruno Biais, Markus Brunnermeier, Douglas Diamond, John Moore, Jean-Charles Rochet and Robert Shimer for useful comments and seminar participants at the Bank of France, Bank of Spain, Bocconi, Bonn, Chicago Booth School of Business, LSE, Maryland and at several conferences (2009 Allied Social Sciences Meetings, Banque de France January 2009 conference on liquidity, Banque de France - Bundesbank June 2009 conference, 8th BIS annual conference "Financial Systems and Macroeconomic Resilience: Revisited", June 2009). The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Emmanuel Farhi & Jean Tirole, 2012. " Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts, " American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February. citation courtesy of