On the Optimal Design of a Financial Stability Fund

Eva Cárceles-Poveda, Yan Liu and Ramon Marimon
Authors registered in the RePEc Author Service: Eva Carceles-Poveda

No 1329, Working Papers from Barcelona School of Economics

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: moral hazard; Debt Overhang; debt contracts; fiscal unions; recursive contracts; partnerships; limited enforcement; debt restructuring; 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-dge and nep-opm
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Citations: View citations in EconPapers (2)

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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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Persistent link: https://EconPapers.repec.org/RePEc:bge:wpaper:1329

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