Financial crisis, efficient bailouts, and regulatory policy

The recent financial crisis generated a great deal of debate about the necessity for, and the quantum of, bailouts. There is also a wide ranging acknowledgement that prudential regulation is necessary to minimize the frequency and intensity of such systemic failures in the future. However, the existing analytical and policy studies tend to deal with these two aspects in isolation. By way of contrast, this study sets up an analytical framework to endogenously determine the requisite regulatory practices and bailout instruments to overcome the liquidity problems and the associated solvency problem on a long term basis. Such efficient choices have been structured to resolve the trade-off between growth and stability by maximizing the welfare of all the parties. Prior knowledge that a well defined bailout policy operates only if they adhere to clearly specified regulatory norms, signals to the financial institutions that keeping risks within bounds will be in the overall interests of all concerned.