The paper develops a theoretical model for support programmes launched by the public sector, i.e. central banks, governments or international organisations, for distressed borrowers in situations of market stress. The model explains why some programmes had little effect, while others were highly effective, even when no support was actually provided.
The bazooka metaphor was first used in 2008, by United States Secretary of the Treasury Hank Paulson, to explain why a massive support fund may be so effective that it might not even have to be used: “If you’ve got a squirt gun in your pocket, you may have to take it out. If you have a bazooka in your pocket and people know it, you probably won’t have to use it.” At that time, the US government committed itself to providing large-scale support to the nation's banks. Its Troubled Asset Relief Program (TARP) ultimately proved effective in reducing interest rates on the bonds of distressed banks. Yet in the end, USD 460 billion of the announced USD 700 billion had to be paid out. Presumably, the programme's effectiveness was driven by the concurrent stress tests to which banks were subjected, which eased concerns about the health of bank balance sheets.
During the European sovereign debt crisis, governments and the ECB took measures to mitigate stress in the market for peripheral sovereign bonds. In 2012, the ECB announced Outright Monetary Transactions (OMT), under which it could purchase sovereign bonds issued by EU member states with an EU/IMF programme. As a result, risk premia on sovereign debt issued by distressed countries plummeted, even though so far the OMT programme has not actually been drawn on.
Besides developing a theoretical model, the paper also derives lessons from case studies, such as support programmes for financial institutions. The German Sonderfonds für Finanzmarktstabilisierung (SoFFin) was relatively successful, in that it brought down interest rates, while only a small proportion of its support funds was actually used. The US TARP was effective, but required the large-scale use of its funds. In Ireland, the Credit Institutions Financial Support Scheme (CIFS) and the Eligible Liabilities Guarantee (ELG) of September 2008 and 2009 seriously undermined the Irish government's solvency, compelling the government to itself request support to avoid default. In this case, the public sector proved unable to deliver on its promise of large-scale support, which seems to have undermined the programme's effectiveness.
The OMT programme was highly effective, as it had no maximum, its creditor (the Eurosystem) was highly solvent and it reduced uncertainty by mitigating the risk of a euro area break-up. Its link with EU/IMF programmes ensures stringent conditions for support (conditionality); governments can only receive support if they take measures aimed at shoring up their solvency.
Bazookas are only effective under certain conditions. Accordingly, the public sector should only commit itself to large-scale support if it is itself sufficiently solvent, can mobilise sufficient firepower and can impose conditions that improve the debtor's solvency. The support provided may go hand in hand with measures that reduce uncertainty, such as stress tests. If the public sector is unable to muster up the resources needed to provide support or cannot impose conditionality, it is well-advised not to make such commitments in order to avoid falling into difficulties, itself.