Government Guarantees and Financial Stability

53 Pages Posted: 7 Mar 2017

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

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Date Written: February 28, 2017

Abstract

Banks are intrinsically fragile because of their role as liquidity providers. This results in under-provision of liquidity. We analyze the effect of government guarantees on the interconnection between banks' liquidity creation and likelihood of runs in a model of global games, where banks' and depositors' behavior are endogenous and affected by the amount and form of guarantee. The main insight of our analysis is that guarantees are welfare improving because they induce banks to improve liquidity provision although in a way that sometimes increases the likelihood of runs or creates distortions in banks' behavior.

Keywords: Panic Runs, Fundamental Runs, Government Guarantees, Bank Moral Hazard

JEL Classification: G21, G28

Suggested Citation

Allen, Franklin and Carletti, Elena and Goldstein, Itay and Leonello, Agnese, Government Guarantees and Financial Stability (February 28, 2017). ECB Working Paper No. 2032. Available at SSRN: https://ssrn.com/abstract=2928537

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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