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The Economists' Voice 2.0The Financial Crisis, Health Care Reform, and More$
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Joseph Stiglitz and Aaron Edlin

Print publication date: 2014

Print ISBN-13: 9780231160155

Published to Columbia Scholarship Online: November 2015

DOI: 10.7312/columbia/9780231160155.001.0001

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Government Guarantees

Government Guarantees

Why the Genie Needs to be Put Back in the Bottle

(p.65) Chapter 8 Government Guarantees
The Economists' Voice 2.0

Viral V. Acharya

Matthew Richardson

Columbia University Press

In the wake of the 2008 financial crisis, this chapter argues for the need to address not just market failures but also regulatory failures arising due to government guarantees. Mispriced government guarantees are pervasive throughout the financial system—inadequately priced deposit insurance, the too-big-to-fail designation, the too-many-to-fail problem, and subsidies provided to government-sponsored enterprises. These distort risk-taking incentives in the system, and their destabilizing effects percolate to the shadow banking world too. The best examples of this activity are the cases of Fannie Mae and Freddie Mac. For every dollar that shareholders put up, they borrowed another twenty-five dollars to invest in risky, relatively illiquid pools of subprime mortgages at very attractive spreads. They took such risks because they could. Correcting this regulatory failure means requiring that financial institutions fully pay in good times for the guarantees they receive ex post, in all likelihood this will organically cause financial firms to no longer take unsound risks.

Keywords:   financial regulation, financial policy, government guarantees, financial institutions, risk taking, financial reform

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