Description

Bailout policy is time-inconsistent, which results in multiple equilibria characterized by too much leverage, high risk correlation and little liquidity holding. I show that a long-run horizon allows the policy-maker to define bailout plans that rule out the worse equilibria. This result contrasts with the standard finding in environments with a unique equilibrium, as in most applications, in which a long-run horizon allows the policy-maker to support superior outcomes in equilibrium. I use this framework to discuss the effectiveness of three prudential policy proposals: too-big-to-fail size caps, taxes on borrowing and liquidity requirements. I also argue that policies alleviating the time-inconsistency of bailouts may generate large welfare gains. In this regard, I discuss three alternatives: policies against the scarcity of liquidity during crises, bailout design, and public debt.