Uncertainty as Commitment
48 Pages Posted: 2 Feb 2013
Date Written: February 2013
Time-inconsistency of no-bailout policies can create incentives for banks to take excessive risks and generate endogenous crises when the government cannot commit. However, at the outbreak of financial problems, usually the government is uncertain about their nature, and hence it may delay intervention to learn more about them. We show that intervention delay leads to strategic restraint banks endogenously restrict the riskiness of their portfolio relative to their peers in order to avoid being the worst performers and bearing the cost of such delay. These novel forces help to avoid endogenous crises even when the government cannot commit. We analyze the effect of government policies from the perspective of this new result.
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