Loan guarantees, bank underwriting policies and financial stability

Loan guarantees represent a form of government intervention to support bank lending. However, their use raises concerns as to their effect on bank risk-taking incentives. In a model of financial fragility that incorporates bank capital and a bank incentive problem, we show that loan guarantees reduce depositor runs and improve bank underwriting standards, except for the most poorly capitalized banks. We highlight a novel feedback effect between banks’ underwriting choices and depositors’ run decisions, and show that the effect of loan guarantees on banks’ incentives is different from that of other types of guarantees, such as deposit insurance.