On the optimal design of a Financial Stability Fund

A financial stability fund set by a union of sovereign countries (e.g. the European Stability Mechanism), can improve countries's ability to borrow and lend, and to share risks, with respect to debt financing. Efficiency gains arise from the ability of the fund to offer long-term financial contracts, subject to limited enforcement and moral hazard constraints. In contrast, debt contracts are subject to untimely roll-over and default risk. We develop a model of the fund as a long-term partnership - with alternative regimes, depending on the constraints it accounts for - and quantitatively compare economies where a country can only use debt contracts with economies within which it has access to different fund contracts. In particular, we characterize how (implicit) interest rates and asset holdings vary across these different regimes. We also study how different regimes react to crisis, the feasibility and possible gains of entering the fund with different levels of accumulated debt, and we contrast episodes of partial default with state-contingent realizations of the long-term fund contract. Of special interest is the case of multi-sided limited enforcement, since the resulting constrained-efficient policies take into account the limited capacity, or political will, of sovereign countries to redistribute funds on a persistent manner. Our simulations show how, even with multi-sided limited enforcement, there are efficiency gains in establishing a well-designed financial stability fund. Hence, our theory provides a basis for its design.