Limiting Risk from Implicit Liabilities
Available evidence suggests that implicit contingent liabilities are by far the most costly.
This is largely due to their open-ended nature, which imposes a cost on the state that is
usually much higher than the cost of explicit liabilities. Indeed, Honohan and Klingebiel
(2003) found that governments that provided, ex-post, open-ended liquidity support and
blanket deposit guarantees incurred much higher costs in resolving financial crises than those
that relied on explicit limited support. The inability of governments to credibly commit
themselves to not bailing out uninsured depositors, interconnected and systemically-
important financial institutions, or farmers affected by natural disasters—with such
commitments frequently proven time inconsistent—creates significant moral hazard, leads to
inadequate loss-prevention efforts on part of the potential beneficiaries, and increases the
cost of the implicit liability. A 2006 survey by the Reserve Bank of Australia showed that
expectations of government bailout were pervasive and powerful, making it politically
difficult for a government to ignore them.
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The survey revealed that the bulk of the
population thinks their deposits are guaranteed or that the government would step in to make
sure that their deposits were repaid in full or in part in the event of a financial institution’s
failure, even though the country had no deposit insurance and in fact had an explicit no-
bailout policy for the financial sector. Since then, the Australian authorities have worked out
more explicit arrangements for giving depositors in failed institutions early access to some of
their funds, with a view to avoiding public expectations of massive bailout and hence control
the risks.
The first line of defense against the risks posed by most implicit contingent liabilities is
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