Government guarantees and contingent capital: Choosing good shock absorbers

Abstract

This paper considers recent experience and proposals for enabling shocks to the banking system to be absorbed without the need for taxpayer funded bailouts. The paper argues that guarantees have an important but limited role to play in the financial safety net, when the operation of financial markets is impaired. It argues further that where possible such guarantees should be priced and reflect the costs that financial institutions would have incurred had markets been functioning normally. In an interconnected international market, guarantees offered by one country tend to have implications for others. For example, when Australia offered guarantees both for wholesale funding and for deposits in the spring of 2008, New Zealand had little choice but to follow within a day or two.This paper explores the range of guarantees employed in a sample of countries in the GFC and other recent crises, particularly the Nordic crises, and contrasts them with alternative means of achieving the same objective.Up until the global financial crisis (GFC) guarantees were well thought of, particularly since they formed an important feature of the quick recovery in the case of the Nordic crises. However, the experience of Ireland in the GFC has revealed their limitation in putting major burdens on the taxpayer, particularly when an important proportion of those being compensated are actually outside the country. The paper contrasts the successful wholesale finance guarantees in Australia and New Zealand with the Crown Deposit Guarantee Scheme in New Zeland which was heavily criticised by the Auditor-General.