Prudential Policies and Bailouts: A Delicate Interaction

Abstract

Could prudential policies backfire by making the lack of commitment problem of bailouts worse? This commitment problem refers to the excessive risk taken by banks and financial institutions in expectations of bailouts if crises occur, which in turn increase financial fragility and the severity of crises. Ex-ante policies, such as prudential policies, have a variety of effects on the various components of the ex-post incentives of an authority to implementing a bailout. Thus, the interaction between prudential policies and bailouts is delicate: In different conditions, a given prudential policy may backfire or increase its effectiveness by worsening or alleviating the lack of commitment problem of bailouts. Liquidity requirements and prudential taxes are examples of prudential policies that may backfire. Public debt is an example of an ex-ante policy usually with no prudential motivation that may play such a role. (Copyright: Elsevier)