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

This paper seeks to show how public reserves with a low return and a partial credit-guarantee scheme can be optimal if banks face a moral hazard problem with both hidden actions and hidden information. The authors use recursive methods to solve for optimal incentive-compatible contracts that require only a relatively small number of constraints and can be computed using current computer technology. Formulating the problem of providing optimal incentive-compatible credit insurance to the banks, it is found 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.