Government guarantees and financial stability

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 global-game model, 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 that sometimes increases the likelihood of runs or creates distortions in banks' behavior

"What Should Banks Do? A Minskyan Analysis"

In this new brief, Senior Scholar L. Randall Wray examines the later works of Hyman P. Minsky, with a focus on Minsky’s general approach to financial institutions and policy. The New Deal reforms of the 1930s strengthened the financial system by separating investment banks from commercial banks and putting in place government guarantees such as deposit insurance. But the system’s relative stability, and relatively high rate of economic growth, encouraged innovations that subverted those constraints over time. Financial wealth (and private debt) grew on trend, producing immense sums of money under professional management: we had entered what Minsky, in the early 1990s, labeled the “money manager” phase of capitalism. With help from the government, power was consolidated in a handful of huge firms that provided the four main financial services: commercial banking, payments services, investment banking, and mortgages. Brokers didn’t have a fiduciary responsibility to act in their clients’ best interests, while financial institutions bet against households, firms, and governments. By the early 2000s, says Wray, banking had strayed far from the (Minskyan) notion that it should promote “capital development” of the economy.

Effects of Fiscal Instability on Financial Instability

This paper empirically examines how fiscal instability affects financial instability. According to an IMF forecast (2021a), the fiscal space in Korea will be steadily reduced in the future. The theoretical literature predicts that if fiscal stability is undermined, financial stability will also be in danger given that government guarantees on banks are weakened and/or sovereign bonds held in banks become riskier. This paper empirically finds the existence of this negative impact of fiscal instability on financial instability. I also find that the intensity of this fiscal-financial relationship is greater in a country where (i) its currency is not a reserve currency such as the US dollar or euro, (ii) its banking sector is large relative to government sector, and/or (iii) its private credit to GDP is high. Korea has all of these three characteristics and hence needs to put more effort into maintaining fiscal stability

e-Quarterly Research Bulletin (Vol. 5, No. 1)

[Excerpt] Macro financial risk propagation and its implications on financial stability have emerged as major concerns of governments and financial institutions, particularly those with large financial asset pools. The global financial crisis in 2008–2009 was essentially centered on credit risk involving money markets, and the propagation of such risk across and among financial institutions and sovereigns is related to how connected they are. To understand the concept of connectedness, Merton provides a brief review of the concepts of credit, credit risk, and guarantees. He asserts that risk- free credit is essentially risky credit coupled with a guarantee of payment in the event of a default. That is, risky debt is nothing but risk-free debt less a guarantee of repayment. We note that in complete contingent markets, the holder of debt always has the option to purchase insurance on the debt, pretty much like the credit default swaps that are available in advanced financial markets today. The guarantee could be issued by a financial institution or a sovereign government, and effectively transfers the risk of default from the borrower to the guarantor. From the perspective of the lending institution, however, the instrument or asset it is holding is now essentially risk-free debt. Merton stresses that the guarantees attached to risky debt are in fact insurance on the risk of default, and are akin to put options on assets of borrowers, with maturities similar to those of the debt instrument being guaranteed and a strike price equivalent to the promised payment of debt

Credit Expansion and Banking Crises: The Role of Guarantees

This paper aims at analysing whether banking changes that occurred in Italy in the last fifteen years have mined the soundness of its financial system. We look for potential threats to financial stability as a result of the dynamic behaviour of Italian banks that progressively have been favouring consumer households at the expense of firms in the allocation of credit. The theme of financial instability is closely linked to the question of capital regulation, which is a centrepiece of government intervention because it affects banks’ soundness and risk taking incentives. After reviewing the literature on capital regulation, we first discuss the role of guarantees as a solution to banks’ potential instability in the case of credit default and, secondly, we estimate a bank interest rate model that explicitly includes collateral and personal guarantees as explanatory variables. We show that banks follow different lending policies according to the type of customer. In the case of firms banks seem to efficiently screen and monitor customers and guarantees (real and personal) are both used to reduce moral hazard problems. In the case of consumer households and sole proprietorships banks behave “lazily” by replacing screening and monitoring activities with personal guarantees; instead, collateral is used to separate good from bad customers (i.e., to mitigate adverse selection problems). These results, together with the large proportion of bad loans in case of unsecured loans, may indicate the existence of potential sources of financial instability because (a) personal guarantees are a small share of loans, especially in the case of consumer households, (b) a decline in the value of collateral held by banks in the event of a housing market weakening.Banking Crisis; Household and Firm Credit Growth; Banking Regulation.

Fiscal risks and the quality of fiscal adjustment in Hungary

The government of Hungary has contained the main fiscal risks of the transition to a market economy. It has paid off and resolved most problems in the banking and enterprise sectors. Since 1995 it has implemented fiscal adjustment with the objective of long-term fiscal stability rather than an immediate deficit target. The main result has been pension reform, which has raised temporary deficits but reduced the long-term public liability. Only the health sector awaits the reform needed for long-term fiscal stability. Levels of government spending, budget deficits, and public service remain high, but the government has made great progress toward rationalizing public spending and improving the management of budget and off-budget fiscal risks. In the transition, the government has taken on new fiscal risks--mainly state guarantees and growing programs of credit and guarantee agencies (operating on behalf of the government) organized after privatization to support, first, industries and, later, exporters. The government has dealt with these new programs of contingent government support prudently and transparently, with reasonable ceilings on (and reporting of) risks. Hungary is likely to face pressure for additional spending. Priorities in fiscal policy should include reforming health financing, establishing checks on hidden subsidies in guarantee programs, and determining the government's optimal exposure to risk. In terms of institutions, the government should aim to create a more flexible, responsive budget process and greater capacity to analyze medium-term fiscal risks, to build a more results-oriented budget management system, and to improve mechanisms for sharing risk between the public and private sectors under government programs.Insurance&Risk Mitigation,Banks&Banking Reform,International Terrorism&Counterterrorism,Payment Systems&Infrastructure,Financial Crisis Management&Restructuring,Banks&Banking Reform,National Governance,Insurance&Risk Mitigation,Municipal Financial Management,Financial Crisis Management&Restructuring

Italy (2008) Capital Injections

In response to the 2007–09 Global Financial Crisis, in October 2008, the Italian government announced urgent measures to guarantee financial stability and the flow of credit. The Italian government targeted three areas of support: (1) bank recapitalizations, (2) liquidity access, and (3) expansion of guarantees on bank deposits. This case study exclusively examines the Italian bank recapitalization scheme introduced in December 2008 in line with European Union State Aid rules. The four Italian banks recapitalized in 2009 under the scheme were Banco Popolare (€1.45 billion), Banca Popolare di Milano (€500 million), Credito Valtellinese (€200 million), and Banca Montepaschi di Siena (€1.9 billion), for an overall amount of €4.05 billion. The government purchased special bonds issued by banks. These bonds became known as “Tremonti bonds,” and Italian regulators agreed to treat them as core Tier 1 regulatory capital

The Role of Central Banks and Competition Policies in the Rescue and Recapitalisation of Financial Institutions During (and in the Aftermath of) the Financial Crisis

Recent years have witnessed a change in focus from considerations of factors which could impede competition, for example over-regulation, to the need to strike a balance between over-regulation and insufficient regulation – in order to provide the right level of safety for consumers (such that they are protected from risky investments). A driving force behind the need for deregulation over the past two decades has been the objective and desire to foster competition. Re-regulation thereafter assumed centre stage in some jurisdictions in response to the need to manage cross sector services' risks more efficiently. Rescue cases involving guarantees (contrasted with restructuring cases) during the recent Financial Crisis, have illustrated the prominent position which the goal of promoting financial stability has assumed over that of the prevention or limitation of possible distortions of competition which may arise when granting State aid. The importance attached to maintaining and promoting financial stability - as well as the need to facilitate rescue and restructuring measures aimed at preventing systemically relevant financial institutions from failure, demonstrate how far authorities are willing to overlook certain competition policies. However increased government and central bank intervention also simultaneously trigger the usual concerns – which include moral hazard and the danger of serving as long term substitutes for market discipline. An interesting observation derives from the relationship between State aid grants, competition, and the potential to induce higher risk taking levels. Whilst the need to promote and maintain financial stability is paramount, safeguards need to be implemented and enforced to ensure that measures geared towards the aim of sustaining system stability (measures such as lender of last resort arrangements and State rescues) do not unduly distort competition as well as induce higher risk taking levels. This paper will draw attention to safeguards which have been provided by the Commission where approval is considered for the grant of State aid to financial institutions whose problems are attributable to inefficiencies, poor asset liability management or risky strategies. Whether the distinction drawn by the Commission – with regards to the preferential grant of recapitalisation packages to fundamentally sound banks (which require less restructuring measures)is justified, will also be considered. How far central banks and governments should intervene and how far distortions of competition should be permitted ultimately depends on how systemically relevant a financial institution is

The role of central banks and competition policies in the rescue and recapitalisation of financial institutions during (and in the aftermath of) the Financial Crisis

Recent years have witnessed a change in focus from considerations of factors which could impede competition, for example over-regulation, to the need to strike a balance between over-regulation and insufficient regulation – in order to provide the right level of safety for consumers (such that they are protected from risky investments). A driving force behind the need for deregulation over the past two decades has been the objective and desire to foster competition. Re-regulation thereafter assumed centre stage in some jurisdictions in response to the need to manage cross sector services' risks more efficiently. Rescue cases involving guarantees (contrasted with restructuring cases) during the recent Financial Crisis, have illustrated the prominent position which the goal of promoting financial stability has assumed over that of the prevention or limitation of possible distortions of competition which may arise when granting State aid. The importance attached to maintaining and promoting financial stability - as well as the need to facilitate rescue and restructuring measures aimed at preventing systemically relevant financial institutions from failure, demonstrate how far authorities are willing to overlook certain competition policies. However increased government and central bank intervention also simultaneously trigger the usual concerns – which include moral hazard and the danger of serving as long term substitutes for market discipline. An interesting observation derives from the relationship between State aid grants, competition, and the potential to induce higher risk taking levels. Whilst the need to promote and maintain financial stability is paramount, safeguards need to be implemented and enforced to ensure that measures geared towards the aim of sustaining system stability (measures such as lender of last resort arrangements and State rescues) do not unduly distort competition as well as induce higher risk taking levels. This paper will draw attention to safeguards which have been provided by the Commission where approval is considered for the grant of State aid to financial institutions whose problems are attributable to inefficiencies, poor asset liability management or risky strategies. Whether the distinction drawn by the Commission – with regards to the preferential grant of recapitalisation packages to fundamentally sound banks (which require less restructuring measures)is justified, will also be considered. How far central banks and governments should intervene and how far distortions of competition should be permitted ultimately depends on how systemically relevant a financial institution is.Competition; central banks; recapitalisation; stability; regulation; financial crises; fundamentally sound financial institutions

A new family of modified Gaussian copulas for market consistent valuation of government guarantees

This paper deals with a copula-based stochastic dependence problem in the context of financial risks. We discuss the financial framework for assessing the theoretical up-front value of government guarantees on bank liabilities. EU States widely use these contracts to improve the financial system’s stability and manage the banking sector in crisis situations; in Italy, they have also been used to address the consequences of the Covid-19 emergency. From a market viewpoint, we deal with a defaultable guarantee contract where the State-guarantor and the bank-borrower are both subject to default risk, and their risks are interconnected. We show that the classical Gaussian copula is not satisfactory for modeling the dependence among the considered risks. Indeed, using the benchmark market model for credit risk portfolio management, we highlight some contradictory results observed for the up-front values of the guarantee when the default intensity of the guarantor is smaller than that of the borrower. Then, we introduce a new family of modified Gaussian copulas that overcomes the limitations of the standard approach, allowing to determine realistic results in terms of the guarantees “mark-to-model” value when the benchmark market model does not work. Numerical simulations validate the theoretical proposal