Should bailouts be allowed? Rutgers’ Todd Keister investigates …

Few aspects of the financial crisis of 2008-9 generated as much outrage as the publicly-funded bailouts of banks and other large financial firms. Following this experience, some economists have called for new laws and regulations that would prevent policy makers from engaging in future bailouts. In recent research, Rutgers Professor Todd Keister asks whether prohibiting bailouts of banks is an effective way to stabilize the financial system.

In a forthcoming paper titled “Bailouts and Financial Fragility,” he shows that while eliminating bailouts would encourage banks to be more cautious, it would also make bank depositors more nervous because they know no help will be available if a crisis starts. If depositors decide to withdraw from their banks at the first sign of trouble, prohibiting bailouts can actually make the economy more susceptible to a crisis. A better approach is to allow bailouts in some circumstances, but to minimize the negative effects on banks’ incentives through enhanced regulation and supervision.

In related work with Vijay Narasiman of Harvard University, Professor Keister investigates how these results depend on the quality of banking regulation. They show that as long as regulation and supervision are effective enough, prohibiting bailouts is always bad idea.  However, if banks are able to easily circumvent regulations, then passing a law that prohibits might be a desirable, if imperfect, solution.

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