DP8248 Financial Black-Holes: The Interaction of Financial Regulation and Bailout Guarantees

Author(s): Romain Rancière, Aaron Tornell
Publication Date: February 2011
Keyword(s): Bailout Guarantees, Derivatives, Financial Crisis, Financial Regulation
JEL(s): E22, E60, F34, G01, G18
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8248

This paper argues that the U.S. financial crisis is a new type of crisis: a "financial black hole." Financial black holes are characterized by the breaking-up of credit market discipline and the large-scale financing of negative NPV projects. In a theoretical model, we explain how the combination of perceived government guarantees and the ability to issues catastrophe-bond-like liabilities generate financial black holes. We then show that the stylized facts of the U.S. economy are consistent with a financial black hole equilbrium.