A theory of bazookas; or, “when (and when not) to use large-scale official sector support”

This paper develops a theoretical model for “bazookas,” a term coined by US Treasury Secretary Hank Paulson in 2008 and since applied to various large-scale public sector support programs for distressed borrowers. The intention behind such programs is to provide so much available financing (“firepower”) as to trigger a complementary market reaction, i.e. a sustained reduction in the borrower’s credit spreads, in turn reducing the probability that support will actually have to be used. With a four-period partial equilibrium framework, and balance sheet interactions between a public sector creditor and distressed borrower, the model formalizes the conditions under which a “bazooka” will be effective. Among other things, the effectiveness in reducing spreads will rise with the size of public sector support funds compared to potential borrowing needs; the creditworthiness of the public sector creditor; and the appropriateness of conditionality under which support is available. This framework helps explain the effectiveness of several recent public sector support programs for banks and sovereigns, in particular the relative success of the ECB’s Outright Monetary Transactions (OMT).
 
Keywords: bazookas, bail-outs, lender of last resort, moral hazard.
JEL classifications: F33, G01, G18.

Working paper no. 479