Government Guarantees and Financial Stability

48 Pages Posted: 27 Apr 2015

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Elena Carletti

Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Agnese Leonello

European Central Bank, Financial Research Division

Multiple version iconThere are 2 versions of this paper

Date Written: April 2015

Abstract

Government guarantees to financial institutions are intended to reduce the likelihood of runs and bank failures, but are also usually associated with distortions in banks' risk taking decisions. We build a model to analyze these trade-offs 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 amount of bank risk taking, but lead banks to take more 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 more efficiency than guarantees against panic-based runs alone. Finally, there are cases where following the introduction of guarantees banks take less risk than would be optimal.

Keywords: bank moral hazard, fundamental runs, government guarantees, panic runs

JEL Classification: G21, G28

Suggested Citation

Allen, Franklin and Carletti, Elena and Goldstein, Itay and Leonello, Agnese, Government Guarantees and Financial Stability (April 2015). CEPR Discussion Paper No. DP10560. Available at SSRN: https://ssrn.com/abstract=2599552

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Elena Carletti

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

Agnese Leonello

European Central Bank, Financial Research Division ( email )

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