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On the Optimal Design of a Financial Stability Fund

Author

Listed:
  • Árpád Ábrahám
  • Eva Cárceles-Poveda
  • Yan Liu
  • Ramon Marimon

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.

Suggested Citation

  • Árpád Ábrahám & Eva Cárceles-Poveda & Yan Liu & Ramon Marimon, 2022. "On the Optimal Design of a Financial Stability Fund," Working Papers 1329, Barcelona School of Economics.
  • Handle: RePEc:bge:wpaper:1329
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    References listed on IDEAS

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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. On the optimal design of a Financial Stability Fund
      by Christian Zimmermann in NEP-DGE blog on 2018-08-01 15:58:27

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    Cited by:

    1. Giovanni Callegari & Ramon Marimon & Adrien Wicht & Luca Zavalloni, 2023. "On a Lender of Last Resort with a Central Bank and a Stability Fund," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 50, pages 106-130, October.
    2. Alessandro Ferrari & Anna Rogantini Picco, 2016. "International Risk Sharing in the EMU," Working Papers 17, European Stability Mechanism.

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    More about this item

    Keywords

    fiscal unions; recursive contracts; Debt Contracts; partnerships; limited enforcement; moral hazard; debt restructuring; Debt Overhang; sovereign fund;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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