IPR Research Notes

Restoring Market Confidence Through Loan-Return Guarantees

Fall 2008 , Volume 30, Number 2

Charles F. Manski

Governments around the world have been intervening in unprecedented ways to help stabilize markets in the wake of the global credit crunch. The causes behind the crisis are complex and still poorly understood, but one of the biggest factors has been market uncertainty. What can governments do to rapidly restore market confidence?

In a new working paper, economists Charles F. Manski, an IPR faculty fellow, and William Brock of the University of Wisconsin–Madison conclude that guaranteeing skittish lenders a minimum return on loans could be one way that governments could—almost immediately—help restore stability and transparency in credit markets.

Most economic models assume that lenders and borrowers have probabilistic expectations that they update as they receive new information following a shock or crisis. Manski and Brock posit, however, that following a large and unexpected shock, market participants may not be sure how to react. In particular, lenders may find it difficult to predict future repayment rates.

Incorporating lenders’ behavior under ambiguity into their model, the economists used various rules—Bayesian, maximin, and minimax-regret—to determine loan supply and credit market equilibrium. Their calculations show that lenders, not being able to determine whether a shock is temporary, reduce loan supply as investors move toward safe assets in a “flight to liquidity.”

The researchers confirm that following a financial shock, government intervention can help to stabilize financial markets by reducing lender doubts about loan repayments and thus preventing the pool of available loans from shrinking further. Loan guarantees are preferable to government manipulation of returns on safe investments, which requires in-depth knowledge of lender behavior.

While acknowledging that their model relies on idealized assumptions and cannot cover all of the complexities of the current credit crisis, Manski and Brock suggest that policymakers might find their analysis pertinent as they seek to create effective stabilization policies.

To download “Competitive Lending with Partial Knowledge of Loan Repayment,” go to www.northwestern.edu/ipr/publications/workingpapers/wpW08.html.