On the optimal regulation of financial guarantees

This paper examines the economic basis for the regulation of financial guarantees or commitments by a third party to provide payments in the event of default. It is argued that regulators can serve as monitors who minimize information or agency costs. However, in the U.S. markets private rating agencies provide such a monitoring function so that regulation is warranted only in the event that there are problems with these private monitors. In addition, since guarantees are directly linked to securitization, regulatory actions that encourage securitization tend to encourage the growth of financial guarantees.