Contingent Liabilities: Issues and Practice; Aliona Cebotari; imf working Paper 08/245; October 1, 2008

In cases where there is strong prima facie evidence that the government would assume 
an implicit contingent liability, costs can be minimized by making the implicit liability 
explicit. To the extent that the implicit guarantees are politically binding and the government 
cannot avoid taking them on (i.e., moral hazard is already present), making an implicit open-
ended guarantee into an explicit, but limited, guarantee would cap the amount of risk 
government is taking and minimize fiscal costs, especially if the government charges the 
beneficiaries for the cost of the explicit guarantee. Examples of making implicit guarantees 
explicit involve the introduction of deposit insurance, flood insurance, and mandatory social 
security.
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A recent example is the intervention of the U.S. government-sponsored housing 
enterprises (Fannie Mae and Freddie Mac) in 2008, which rendered the government’s 
longstanding implicit guarantee of their liabilities explicit. The disadvantages of taking on an 
explicit liability can be dealt with through the design of the framework that replaces the 
implicit liability. Elements of such a framework would include: (i) compulsory membership 
in the insurance program, which only the government has the advantage of enforcing—this 
would overcome traditional pitfalls of private insurance markets such as adverse selection; 
(ii) tools to blunt moral hazard, such as capping the insured risk, requiring information 
disclosure, requiring loss-mitigation efforts, and using information available though the 
government’s tax system to enforce loan repayment—in most of these cases using an 
advantage that only the government has (Stiglitz, 1993); (iii) charging a premium that reflects 
risks; and (iv) putting in place clear frameworks for dealing with residual risks not 
guaranteed by the government. An example of the latter would be comprehensive 
frameworks for dealing with bank failures and for strengthening prudential supervision, 
which would both minimize risks faced by the government and create clear expectations of 
what happens after the government guarantee is exhausted.
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As Stiglitz pointed out: “One of the arguments for compulsory Social Security is that, should an individual 
fail to save for retirement, the government will find it impossible to look the other way and let that person suffer 
the consequences” (FRBC, 1991, p. 113). 
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In the case of deposit guarantees, the introduction of a limited explicit guarantee should be undertaken during 
quiet times. 

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