Collective Moral Hazard, Liquidity Evaporation and Time-Consistent Bailouts

Abstract

I study the time-inconsistency problem of financial bailouts when entrepreneurs (banks) correlate their aggregate risk exposure, events of "liquidity evaporation" may be triggered during financial distress, and the authority internalizes the future effects of its policies. I find that supporting smaller time-consistent bailouts generates large welfare gains. For this goal, I study a variety of types of policy may serve as substitute of increasing discounting. In contrast to the related literature (Farhi and Tirole, 2009; Chari and Kehoe, 2009), I point out on the role of policy during or after financial crises instead of prudential policy (before crises).