Government Guarantees and Financial Stability
Franklin Allen
Imperial College and University of Pennsylvania
Elena Carletti
Bocconi University, IGIER and CEPR
Itay Goldstein
University of Pennsylvania
Agnese Leonello
European Central Bank
December 15, 2015
Abstract
Government guarantees to
nancial institutions are intended to reduce the likelihood of runs and
bank failures, but are also usually associated with distortions in banksrisk taking decisions. We build a model to analyze these trade-o¤s based on the global-games literature and its application to bank runs. We derive several results, some of which against common wisdom. First, guarantees reduce the probability of a run, taking as given the deposit contract set by the bank, but lead banks to take more liquidity risk, which in turn might lead to an increase in the probability of a run. Second, guarantees against fundamental-based failures and panic-based runs may lead to greater e¢ ciency than guarantees against panic-based runs alone. Finally, there are cases where following the introduction of guarantees banks take less liquidity risk (and more solvency risk) than would be optimal.
Keywords: panic runs, fundamental runs, government guarantees, bank moral hazard