Sometimes, the threat of a financial bazooka — massive financial support programs launched by governments, central banks or international organizations to support financial sectors — is all it takes to turn around investor sentiment.
New research examining when bazookas are effective states that a bazooka is most effective if investors believe potential public-sector support will materially improve their chances of being repaid — making the investor more likely to continue to lend. That could mean actual support from the public sector is not needed, said a working paper by the Netherlands' central bank, De Nederlandsche Bank, “A Theory of Bazookas; or, When (and When Not) to Use Large-Scale Official Sector Support.”
Written by Jon Frost, an economist in DNB's financial stability division, the paper outlines a theoretical model for when bazookas are likely to work. The paper examines support programs for banks, such as the U.S. Troubled Asset Relief Program, and sovereign support programs.
Of the sovereign programs, the paper said the European Central Bank's Outright Monetary Transactions program — under which the ECB can purchase sovereign bonds of distressed eurozone markets — “is the only program so far that actually meets the strict definition of a "bazooka.'” The paper said the combination of large central bank firepower, conditionality of support and a reduction in uncertainty “is likely the key to OMT's effectiveness in putting an end to sovereign stress in the euro area, thereby making actual support unnecessary.”
