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On the optimal design of a Financial Stability Fund

Author

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  • Ramon Marimon

    (European University Institute & UPF - Barcelona GSE)

  • Eva Carceles-Poveda

    (SUNY at Stony Brook)

  • Arpad Abraham

    (European University Institute)

Abstract

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.

Suggested Citation

  • Ramon Marimon & Eva Carceles-Poveda & Arpad Abraham, 2012. "On the optimal design of a Financial Stability Fund," 2012 Meeting Papers 945, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:945
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    References listed on IDEAS

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    1. Bulow, Jeremy & Rogoff, Kenneth, 1989. "Sovereign Debt: Is to Forgive to Forget?," American Economic Review, American Economic Association, vol. 79(1), pages 43-50, March.
    2. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-1089, July.
    3. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
    4. Ábrahám, Árpád & Cárceles-Poveda, Eva, 2010. "Endogenous trading constraints with incomplete asset markets," Journal of Economic Theory, Elsevier, vol. 145(3), pages 974-1004, May.
    5. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    6. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
    7. 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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    Cited by:

    1. Alessandro Ferrari & Anna Rogantini Picco, 2016. "International Risk Sharing in the EMU," Working Papers 17, European Stability Mechanism.

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