Working Paper: NBER ID: w15138
Authors: Emmanuel Farhi; Jean Tirole
Abstract: 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.
Keywords: moral hazard; maturity mismatch; systemic risk; monetary policy; regulation
JEL Codes: E44; E52; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased maturity transformation by banks (G21) | Higher leverage choices (G11) |
| Higher leverage choices (G11) | Central bank lowers interest rates (E52) |
| All banks engage in maturity transformation (G21) | Central bank has little choice but to intervene (E58) |
| Anticipation of monetary bailouts (E44) | Banks' risk exposure decisions (G21) |
| Banks' risk exposure decisions (G21) | Correlate their risk profiles (C10) |
| Central bank's non-targeted monetary policy (E52) | Low interest rates benefit risky institutions (G21) |
| Banks with high leverage (G21) | More likely to receive monetary bailouts (G28) |
| Low interest rates for distressed banks (G21) | Long-term risks for the financial system (F65) |
| Optimal regulation involves minimum liquidity requirement (G18) | Mitigate risks associated with excessive maturity transformation (G33) |