On the optimal design of a Financial Stability Fund∗

A Financial Stability Fund set by a union of sovereign countries (e.g. the European Stability Mechanism) can improve countries’ ability to share risks, borrow and lend, with respect to the standard instrument: sovereign debt financing. Efficiency gains arise from the ability of the fund to offer long-term contingent financial contracts, subject to limited enforcement and moral hazard constraints. In contrast, debt contracts are subject to untimely debt roll-overs and default risk. We develop a model of the Financial Stability Fund (FSF ) as a long-term partnership with limited commitment (limited ex-post transfers). We quantitatively compare the constrained-efficient FSF economy with the incomplete markets economy with default. In particular, we characterize how (implicit) interest rates and asset holdings differ, as well as how both economies react differently to the same productivity and government expenditure shocks. In our calibrated economies (to world TFP series) there are important efficiency gains in establishing a well-designed Financial Stability Fund ; particularly, when economies experiment negative shocks. Our theory provides a basis for the design of a FSF and a theoretical framework to assess similar mechanisms (e.g. the combination of the ESM and the Outright Monetary Transactions ECB mechanism). JEL classification: E43, E44, E47, E63, F34, F36