The Defaultable Guarantee Contract

The Member States guarantee the safeguarding of the euro and the stability of the banking system through a ‘new’ type of contract which we will call a defaultable guarantee contract. A defaultable guarantee contract is quite peculiar with respect to a standard one. In fact, in a standard guarantee, the borrower is subject to default risk but the guarantor is default-free (so that its risk does not depend on the risk of the borrower). In contrast, in a defaultable guarantee contract, (i) both obligors are exposed to counterparty default risk and the risk of the guarantor could be higher than that of the borrower, and (ii) there may be a form of dependence between the default risks of the guarantor and those of the borrower. For example, it is clear that the pattern of default risk which characterises the European Stability Mechanism (ESM) scheme of public aid to Member States is ‘circular’, because the States are at the same time guarantors and shareholders of the fund, as well as potentially assisted parties (partly ‘self-assisted’). There is also a correlation effect in the case of a government guarantee covering bank debt, as ‘the link between the condition of sovereign borrowers and that of their domestic banking systems has been a key feature of the global financial crisis’.1