Guarantees, risk shifting and credit crunches

Abstract

This paper analyzes the role of guarantees when a policymaker wants to avoid a credit crunch, but at the same time is concerned that its policies may lead to excessive risk taking. Banks face a coordination problem in their investment decisions and are allowed to risk-shift to projects with smaller expected return and higher volatility. Government guarantees can avoid a freeze in funding at the cost of increasing risk-shifting behavior. When fundamentals are sufficiently low, the policymaker prefers not to intervene and a credit crunch happens. The moral hazard problem makes guarantees more powerful, reducing the amount of guarantees needed to avoid a coordination failure.