Government intervention, linkages and financial fragility

Abstract

We examine how financial integration affects financial stability and what government intervention maximizes stability and well-being, in a setup where depositors can obtain information on the quality of investments in their bank but there is a friction that prevents them from determining the quality of the investments of the other banks in the system. In this way, depositors will try to withdraw their deposits when they observe that the expected profitability in their bank is low. This situation will lead to a contagion problem as troubled banks may be forced to liquidate their investments in other banks. To prevent this contagion risk and reduce the costs of crises, we look at various policies governments can use, such as recapitalizing troubled banks, increasing capital requirements, or a lender-of-last-resort policy.