Government intervention in response to the subprime financial crisis: The good into the pot, the bad into the crop

The subprime-related 2007/2008 global financial crisis represented a major economic challenge. In order to prevent such episodes of market failure, it is vital to understand what caused the crisis and which lessons are to be learned. Given the tremendous bailout packages worldwide, we discuss the role of governments as lenders of last resort. In our view, it is important not to suspend the market mechanism of bankruptcy via granting rescue packages. Only those institutions which are illiquid but solvent should be rescued, and this should occur at a significant cost for the respective institution. We provide a formal illustration of a rescue mechanism, which allows to distinguish between illiquid but solvent and insolvent banks. Furthermore, we argue that stricter regulation cannot be the sole consequence of the crisis. There appears to be a need for improved risk awareness, more sophisticated risk management and a better alignment of interests among the participants in the market for credit risk.Financial crisis Government intervention Bailout Risk management Credit derivatives Securitization