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On the optimal design of a Financial Stability Fund

Author

Listed:
  • Arpad Abraham
  • Eva Carceles-Poveda
  • Yan Liu
  • Ramon Marimon

Abstract

A Financial Stability Fund set by a union of sovereign countries can improve countries' ability to share risks, borrow and lend, with respect to the standard instrument used to smooth fluctuations: sovereign debt financing. Efficiency gains arise from the ability of the fund to over long-term contingent financial contracts, subject to limited enforcement (LE) and moral hazard (MH) constraints. In contrast, standard sovereign debt contracts are uncontingent and subject to untimely debt roll-overs and default risk. We develop a model of the Financial Stability Fund (Fund) as a long-term partnership with LE and MH constraints. We quantitatively compare the constrained-efficient Fund economy with the incomplete markets economy with default. In particular, we characterize how (implicit) interest rates and asset holdings differ, as well as how both economies react differently to the same productivity and government expenditure shocks. In our economies, "calibrated" to the euro area "stressed countries", substantial efficiency gains are achieved by establishing a well-designed Financial Stability Fund; this is particularly true in times of crisis. Our theory provides a basis for the design of a Fund - for example, beyond the current scope of the Euroepan Stability Mechanism (ESM) - and a theoretical and quantitative framework to assess alternative risk-sharing (shock-absorbing) facilities, as well as proposals to deal with the euro area "debt overhang problem."

Suggested Citation

  • Arpad Abraham & Eva Carceles-Poveda & Yan Liu & Ramon Marimon, 2018. "On the optimal design of a Financial Stability Fund," Department of Economics Working Papers 18-06, Stony Brook University, Department of Economics.
  • Handle: RePEc:nys:sunysb:18-06
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    File URL: https://www.stonybrook.edu/commcms/economics/research/papers/2018/FSF_1806.pdf
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    References listed on IDEAS

    as
    1. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    2. Fernando Alvarez & Urban J. Jermann, 2000. "Efficiency, Equilibrium, and Asset Pricing with Risk of Default," Econometrica, Econometric Society, vol. 68(4), pages 775-798, July.
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    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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