Government Guarantees and the Two-way Feedback between Banking and Sovereign Debt Crises

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1 Government Guarantees and the Two-way Feedback between Banking and Sovereign Debt Crises Agnese Leonello European Central Bank 7 April 2016 The views expressed here are the authors and do not necessarily reflect those of the ECB or the Eurosystem.

2 Introduction Government guarantees to financial institutions are common all over the world and take different forms Deposit insurance or implicit guarantees for a bailout The recent crisis has renewed the debate on their desirability: They help preventing the occurrence and the consequences of panics (Diamond and Dybvig, 1983) But, they may entail large costs for the government providing them Negative impact on sovereign s solvency undermines the credibility and effectiveness of guarantees Guarantees may trigger a vicious circle between banks and sovereigns (e.g., Irish crisis)

3 What I do in the paper I develop a model to fully analyze the role that government guarantees play in linking banks and sovereign stability What is needed: Endogenizing the probability of a run on banks to see how it is affected by government guarantees and government s available resources Endogenizing government s budget to see how it is affected by government guarantees, taking into account depositors withdrawal decisions Allowing the occurrence of both panic (i.e., liquidity) and fundamental (i.e., solvency) crises I put all these ingredients together and derive some new results on the desirability of government guarantees and their implications for sovereign stability

4 What s new I: Literature on government guarantees In the existing literature, government guarantees are assumed to be Feasible: the government has always enough resources to finance the guarantees Credible: depositors are sure to receive the guaranteed amount In this context, they are Fully effective and costless if banking crises are a pure panic phenomenon (e.g., Diamond and Dybvig, 1983) Costly (moral hazard) if crises are also related to a deterioration of the banks assets Here, the feasibility and credibility of the guarantees are determined endogenously Thus, even abstracting from moral hazard considerations, guarantees may be costly and not fully effective in preventing crises

5 What s new II: Literature on banks-sovereigns nexus In the existing literature, spillovers between banking and sovereign debt crises are analyzed assuming Exogenous probabilities guarantees (bailouts) mitigate the negative effects of a crisis but no effect on the source of the crisis Only one type of crisis either panic- or fundamental-based In this context, guarantees Account only for a part of the feedback loop Spread fragility from banks to the government Here, the government s disbursement and the probabilities of crises are completely endogenous and affected by each other Thus, guarantees alone can trigger a feedback loop between banking and sovereign debt crises and it can be a positive loop

6 Sketch of the model I Three date economy t = 0, 1, 2 with a banking sector and a sovereign bonds market Banks and government are fragile in that they are exposed to rollover risk Banking crisis as in Goldstein and Pauzner (2005) A continuum of mass 1 of risk- averse domestic consumers hold deposits into a bank and they have to decide when to withdraw their funds Depositors { are promised } c 1 > 1 if they withdraw at date 1 and max 1 t nc1 1 n R, 0 at date 2 only if the project of the bank succeeds Banks invest in a risky project returning R = { R > 1 w.p. p (Y ) 0 w.p. 1 p (Y )

7 Sketch of the model II Sovereign default as a self-fulfilling debt crisis in the spirit of Cole and Kehoe (2000) A continuum of mass 1 of risk- netural foreign investors hold sovereign bonds and they have to decide whether to roll over their investment or not Sovereign creditors receive r G 0 1 if they withdraw at date 1 and r G 1 r G 0 at date 2 only if government is solvent The government is solvent if G (Y, I (i, t, r B0 )) (1 i)r G 1 g 0 Creditors payoffs at date 2 positively depend on the growth rate of the domestic economy Y and negatively on the proportion (n, i) of other creditors withdrawing prematurely All agents take their withdrawal decision based on an imperfect signal about Y, with Y U[0, 1]

8 Creditors withdrawal decision and crises Lower dominance Intermediate Upper dominance Y j Yj Y j creditors creditors no withdraw withdraw creditor because of low Y because of withdraws solvency Y and others no crises crises panics Crises occur when the fundamentals are below a unique threshold and can be liquidity-driven: Y is high but many creditors withdraw early, or solvency-driven: Y is low

9 Introducing the guarantees The government guarantees depositors to receive a minimum repayment irrespective of how many people run Government promises to transfer resources to banks after the first γ depositors have withdrawn The actual amount transferred may be smaller, as government s available resources depend on how many investors rollover Depositors and investors actions are strategic complements. For a given size of the guarantee, The proportion of investors rolling over the bonds determines the amount that the government can transfer to the banking sector in the case of a crisis The proportion of depositors running determines the amount that the government needs to subtract from its budget and to transfer to the banking sector

10 From no guarantees to full guarantees Guarantees do not eliminate panic bank runs and lead to a higher probability of sovereign default and higher interest rate on sovereign bonds

11 Looking deeper into the various effects The size of the guarantees γ affects directly and indirectly the probabilities of the two crises For a given i, depositors have a lower incentive to withdraw at date 1 the probability of a bank run decreases For a given n, investors have a lower incentive to roll over the bonds at date 1 the probability of a sovereign default increases The increase in the probability of a sovereign default reduces the credibility of the guarantees the probability of a bank run increases The decrease in the probability of a run reduces the disbursement for the government the probability of a sovereign default decreases

12 Increasing the size of the guarantees An increase in the size of the guarantees γ reduces both the probability of a bank run and that of a sovereign default if Pr bank run γ > Pr sovereign default γ Intuition: as the guarantee increases, the government has a larger disbursement in the case a run occurs, but the likelihood that a run occurs and, in turn, that it has to pay decreases The expected disbursement for the government decreases when the latter effect dominates the former. Thus, investors have a higher incentive to roll over the bonds The condition above is more likely to hold in economies where: Banking crises are mainly panic-driven Government budget is sounder

13 Austerity measures Cutting public expenditure g and increasing taxes t improve government budget and thus positively affect is solvency Indirect positive effect on the credibility and effectiveness of the guarantees However, the two measures have different effects on the stability of the banking sector and sovereign debt market Reducing public expenditure reduces both the probability of a sovereign default (directly) and that of a bank run (indirectly) Increasing taxes has an ambiguous effect as it affects both depositors and investors payoff but in opposite directions

14 When austerity may backfire... Increasing taxes has three effects in this framework: It improves government s budget It reduces the size of the banking sector (1 t is the size of the bank) It makes the coordination problem between depositors more severe The first two effects improve overall stability, the last one has the opposite effect Austerity based on tax increase backfires if Pr bank run t > Pr sovereign default t and the effect of austerity on the real sector...what if austerity affects the distribution of Y?

15 Conclusions Government guarantees present a complicated trade-off and understanding it requires endogenizing depositors behavior in response to government intervention and government budget Even abstracting from moral hazard considerations, guarantees may entail large costs and be not fully effective in preventing banking crises An increase in the support that government offers to banks do not always lead to a "vicious circle" like in Ireland Countries implementing the same level of guarantees may differ significantly in terms of their effects on the banks and government stability depending on the specific characteristics of the economy