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Malherbe, Frederic; McMahon, Michael
Journal of monetary economics, July 2024, Volume: 145Journal Article
Government guarantees of bank liabilities have a long-standing history and are now ubiquitous. We study a model where financial sophistication enhances banks’ ability to exploit government guarantees and fuels inefficient economic booms. Driven by financial engineering, bank rent extraction creates a disconnect between lending decisions and borrower repayment prospects: In equilibrium, banks over-lend and only break-even courtesy of trading book profit. Exploitability is affected not only by financial sophistication but also by regulation. Given the pattern for regulatory changes in the last few decades, we posit that the Great Recession, partly, reversed a Great Distortion. •Government guarantees of bank debt are widespread around the world.•These guarantees can be exploited but, in a simple world, the effect is relatively mild.•We show that financial sophistication enhances banks’ ability to exploit guarantees.•Such exploitation fuels inefficient economic booms and distorts economic activity.
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