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Discussion Paper Details

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Title: Government Guarantees and Financial Stability

Author(s): Franklin Allen, Elena Carletti, Itay Goldstein and Agnese Leonello

Publication Date: April 2015

Keyword(s): bank moral hazard, fundamental runs, government guarantees and panic runs

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Allen, F, Carletti, E, Goldstein, I and Leonello, A. 2015. 'Government Guarantees and Financial Stability'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10560