We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it...

Capital flight associated with the onset of a financial crisis in a country is often accompanied by an inflow of capital associated with foreign direct investment (FDI). Our paper provides a theoretical framework for this puzzle, and draws wider conclusions on the welfare effects of foreign...

We study liquidity transfers between banks through the interbank borrowing and asset sale markets when (i) surplus banks providing liquidity have market power, (ii) there are frictions in the lending market due to moral hazard, and (iii) assets are bank-specific. We show that when the outside...

Systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks...

Fire sales that occur during crises beg the question of why sufficient outside capital does not move in quickly to take advantage of fire sales, or in other words, why outside capital is so slow-moving. We propose an answer to this puzzle in the context of an equilibrium model of capital...

Bank liquidity is a crucial determinant of the severity of banking crises. In this paper, we consider the effect of fire sales and foreign entry on banks' ex ante choice of liquid asset holdings, and the ex post resolution of crises. In a setting with limited pledgeability of risky cash flows...

The merit of having international convergence of bank capital requirements in the presence of divergent closure policies of different central banks is examined. While the privately optimal level of bank capital decreases with regulatory forbearance (they are strategic substitutes), the socially...

This Paper shows that bank closure policies suffer from a ‘too-many-to-fail’ problem: when the number of bank failures is large, the regulator finds it ex-post optimal to bail out some or all failed banks, whereas when the number of bank failures is small, failed banks can be acquired by the...

Two aspects of systemic risk, the risk that banks fail together, are modeled and their interaction examined. First, the ex-post aspect, in which the failure of a bank brings down a surviving bank as well, and second, the ex-ante aspect, in which banks endogenously hold correlated portfolios...

As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in ‘cash-in-the-market’ pricing for liquidation of banking assets. At a...