Recent events in the financial world have seen various countries come up with bailout packages and blanket guarantees for loans. The rationale for such guarantees is to prevent ?crises of expectation?. These are liquidity crises generated when investors pull out their money, believing that the financial institution could soon be insolvent. But what are the long-run costs to such guarantees? Luc Laeven and Fabian Valencia of the IMF discuss this in their latest working paper ?The Use of Blanket Guarantees in Banking Crises?. They find that while guarantees do help reduce liquidity crises in the banking system, they are fiscally very costly and can be effectively issued only by credible governments.

A blanket guarantee is an announcement by a guarantor that they would unconditionally guarantee the assets of a financial institution, or class of financial institutions. For example, last year the UK announced a blanket guarantee to all assets of Northern Rock. This allows greater confidence in the solvency of the financial institution or bank, and prevents the threat of a ?bank run?. These guarantees can be issued across all institutions (such as Denmark?s announcement in Oct 2008) or for a specific institution (such as the UK guarantee). They can be issued in consonance with bank restructuring programs or can be the sole policy instrument that a government uses for a potential liquidity crisis.

It is difficult to measure the success of a guarantee, since the desired impacts are largely expectation-oriented. One possible outcome of a successful guarantee is that the financial institution would not run into a liquidity crisis, and would demand less short-term credit. Laeven and Valencia therefore measure the ?impact? of the guarantee by the financial institution?s demand for credit from the central bank. They find that the impact of a bank guarantee is inter-woven with many other factors, including IMF intervention, currency depreciation and level of foreign exchange reserves. However, there is a significant positive impact of a blanket guarantee on liquidity support from the central banks. They also find that a blanket guarantee across all banks is more effective than that across a few specific banks. Moreover, foreign liabilities are almost completely unresponsive to guarantees by domestic governments, although they respond significantly to bank restructuring programs.

While there is evidence that guarantees have positive impacts under certain conditions, they also have significant costs. In fact, the costs of a guarantee are inversely proportional to its impacts?a successful guarantee has lesser chances of being called in, and therefore lower costs. Laeven and Valencia find that the fiscal costs of issuing guarantees can be direct (raising outlays to pay off depositors of failed institutions, or absorption of failed assets) or indirect (exacerbating risky behavior). The indirect component, termed as ?moral hazard? can lead to risky behaviour by both banks and individuals. The direct component is tougher on taxpayers, at least in the short run. It varies based on the level of credibility of the guarantor (more credible guarantors have lower costs), but the paper estimates that it can be as high as 58% of GDP.

They also find that the impact of guarantees is higher over the medium term than the short term. While this result seems counter-intuitive, it reinforces the core message which is that while blanket guarantees help anchor depositor?s expectations, they have to be supplemented by concrete measures such as recapitalising banks, paying off depositors, setting up an institutional framework to deal with non-performing assets etc. If these credible policy actions are not taken, the impact of guarantees is diluted, and their costs increased.

Overall, Laeven and Valencia find that unless blanket guarantees are followed up by concrete policy measures, their impacts are only temporary. This is a useful insight for many emerging economies, as guarantees may seem like a pre-emptive and ?easy to implement? option to combat a liquidity crunch.

?The author is consultant, National Institute of Public Finance & Policy. These are her personal views