On the optimal design of a financial stability fund

Árpád Ábrahám, Eva Carceles-Poveda, Yan Liu and Ramon Marimon (ramon.marimon@upf.edu)
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Ramon Marimon: https://www.upf.edu/web/econ/faculty/-/asset_publisher/6aWmmXf28uXT/persona/id/3418929

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: We develop a model of a Financial Stability Fund (Fund) for a union of sovereign countries. By contract design, the Fund never has expected undesired losses while, being default-free, a participant country has greater ability to borrow and share risks than using sovereign debt financing. The Fund contract also provides better incentives for the country to reduce endogenous risks. These efficiency gains arise from the ability of the Fund to offer long-term contingent financial contracts, subject to limited enforcement (LE) and moral hazard (MH) constraints as part of the contingencies. We develop the theory (welfare theorems, with a new price decentralization) and quantitatively compare the constrained-efficient Fund economy with an incomplete markets economy with default. In particular, we characterize how prices and allocations differ, when the two economies are subject to exogenous productivity and endogenous government expenditure shocks. In our economies, calibrated to the euro area 'stressed countries', substantial welfare gains are achieved, particularly in times of crisis. The Fund is, in fact, a risk-sharing, crisis prevention and resolution mechanism, which transforms participant countries’ defaultable sovereign debts into union’s safe assets. In sum, our theory can help to improve current official lending practices and, eventually, to design an European Fiscal Fund.

Keywords: fiscal unions; recursive contracts; Debt Contracts; partnerships; limited enforcement; moral hazard; debt restructuring; Debt Overhang; sovereign fund (search for similar items in EconPapers)
JEL-codes: E43 E44 E47 E63 F34 F36 (search for similar items in EconPapers)
Date: 2022-03
New Economics Papers: this item is included in nep-ban, nep-cta, nep-dge, nep-eec and nep-mac
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Related works:
Working Paper: On the Optimal Design of a Financial Stability Fund (2022)
Working Paper: On the optimal design of a Financial Stability Fund (2018)
Working Paper: On the optimal design of a Financial Stability Fund (2016)
Working Paper: On the optimal design of a Financial Stability Fund (2012)
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