Credit Guarantees, Moral Hazard, and the Optimality of Public Reserves

In this paper we show that public reserves with a low return and a partial creditguarantee scheme can be optimal if banks face a moral hazard problem with both hidden actions and hidden information. In our model, banks face uncertain returns on their loans or investments, and both the level of investment and the actual returns are unobservable to anyone but the bank itself. We formulate the problem of providing optimal incentive-compatible credit insurance to the banks, and find that the optimal contract has the feature that low-return public reserves are used. This occurs even though public reserves are dominated in return by other investments, and would not be used in a full-information environment. In order to compute the optimal partial insurance scheme, we develop general recursive methods to solve for optimal contracts in dynamic principal-agent models with hidden income and hidden actions. We are grateful to Harold Cole, Hugo Hopenhayn, Ruilin Zhou, and seminar participants at Chicago, MIT, Boston University, IIES, and the SED meeting in San Jose for helpful comments. Department of Economics, UCLA, Box 951444, Los Angeles, CA 90095. E-mail address: [email protected]. Department of Economics, The University of Chicago, 1126 East 59th Street, Chicago, IL 60637. E-mail address: [email protected]. 1