Academic journal article The Cato Journal

How Large Is the Federal Financial Safety Net?

Academic journal article The Cato Journal

How Large Is the Federal Financial Safety Net?

Article excerpt

In the 1980s and early 1990s, U.S. taxpayers paid $130 billion to make good on the federal government's guarantee to protect depositors in thrift institutions (U.S. GAO 1996: 14). The crisis affecting thrifts in the late 1980s exhausted the funds that had been set aside by the deposit insurance agency, and made it necessary for Congress to allocate new funds. This period marked the first major test of the federal deposit insurance system since its inception in 1933. The system was badly stressed, but it did succeed in one sense. Although there were a large number of bank failures, the type of bank runs and widespread panics seen in crises prior to the creation of the Federal Deposit Insurance Corporation (FDIC) did not occur. Deposit insurance gave the average bank depositor a sense of safety not previously enjoyed. With this protection, however, depositors have little interest in paying attention to the riskiness of their banks' lending activities. Many observers argue that a lack of depositor scrutiny contributed to the problems experienced by banks and thrifts in the 1980s.

The government's interest in the safety of private savers and private financial institutions did not begin with the creation of deposit insurance. Indeed, in the earliest years of the republic the government sometimes reallocated the deposits it held with private banks in order to provide additional funding to a distressed institution (Studenski and Kroos 1963: 72-73). Even J. P. Morgan received government assistance in his efforts to rescue troubled institutions in the wake of the panic of 1907. While this episode is often cited as a case in which the government provided no support, the U.S. Treasury contributed $25 million at a crucial point to assure the completion of a successful rescue.

The federal government's financial support for private borrowers is not limited to banks and other financial institutions. On some occasions, the government has stepped in to assist large nonfinancial corporations that were in financial distress, as in the bailout of Chrysler in 1980. Government protection for the creditors of nonfinancial corporations arose again in the aftermath of the terrorist attacks of September 11, 2001, with the passage of the Air Transportation Safety and System Stabilization Act, providing up to $10 billion in loan guarantees to the airline industry. In addition, many government programs help individuals receive credit to finance small business development, home purchases, or other endeavors. This assistance is often in the form of loan guarantees under which the government pays the lender if the borrower defaults.

The various forms of federal government support for private borrowers comprise the federal financial safety net. In this article we estimate the size of the safety net. Specifically, we examine the extent to which the liabilities of private market participants are perceived to enjoy federal government guarantees. Our estimate includes a mixture of elements. Some of the liabilities, such as insured deposits, are explicitly guaranteed. Others, such as some deposit balances in excess of the limits on explicit deposit insurance and the liabilities of certain government-sponsored enterprises, are believed by many market participants to be implicitly guaranteed by the federal government. Our approach to implicit guarantees is to ask, "Based on past government actions, what might market participants reasonably expect future government actions to be?"

We estimate that explicitly guaranteed liabilities amount to $5.8 trillion and that implicitly guaranteed liabilities amount to $3.4 trillion, which implies that the total safety net is in the neighborhood of $9.2 trillion, or about 26 percent of total private liabilities. While we believe this figure reasonably suggests the safety net's size, we should emphasize that it is an estimate, including a variety of elements and reflecting our judgment regarding what should and should not be included. …

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