Risk-bearing by the state: When is it good public policy?

•Based on a review of economic frictions, this paper concludes that the common justifications for government guarantees are flawed.•State's main advantage over markets is in resolving the collective action frictions that hinder risk spreading.•To exploit this advantage, development banks have to price guarantees fairly, crowd in the private sector, and reduce excessive risk aversion.•This requires significant changes in development banks’ mandates, governance, and risk management systems.

The global financial crisis brought government guarantees to the forefront of the debate. Based on a review of frictions that hinder financial contracting, this paper concludes that the common justifications for government guarantees—i.e., principal-agent frictions or un-internalized externalities in an environment of risk neutrality—are flawed. Even where risk is purely idiosyncratic—and thus diversifiable in principle—government guarantees (typically granted via development banks/agencies) can be justified if private lenders are risk averse and because of the state's comparative advantage over markets in resolving the collective action frictions that hinder risk spreading. To exploit this advantage while keeping moral hazard in check, however, development banks/agencies have to price their guarantees fairly, crowd in the private sector, and reduce their excessive risk aversion. The latter requires overcoming agency frictions between managers and owner (the state), which would likely entail a significant reshaping of development banks’ mandates, governance, and risk management systems.