Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

How Large Has the Federal Financial Safety Net Become?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

How Large Has the Federal Financial Safety Net Become?

Article excerpt

In 2002, Walter and Weinberg examined the federal financial safety net as it stood at the end of 1999 (Walter and Weinberg 2002). At the time, the authors estimated that approximately 45 percent of all financial firm liabilities were protected by the safety net. As one would expect in this article, the current estimate indicates that the size of the net has grown, as the financial market turmoil that began in 2007 led federal government agencies to expand the range of institutions and the types of liabilities protected by the safety net.

1. THE SAFETY NET: ITS DEFINITION, COSTS, AND BENEFITS

Walter and Weinberg defined the federal financial safety net as consisting of all explicit or implicit government guarantees of private financial liabilities. Private financial liabilities are those owed by one private market participant to another. As used by Walter and Weinberg, the phrase government guarantee means a federal government commitment to protect lenders from losses due to a borrower's default (Walter andWeinberg 2002).1 Following this definition, we include in our estimate of the safety net, insured bank and thrift deposits, certain other banking company liabilities, some government-sponsored enterprise (GSE) liabilities, selected private employer pension liabilities, as well as a subset of the liabilities of other financial firms. The details of why we chose to include these liabilities are provided below.

Effect of a Safety Net on Economic Efficiency

Government actions in the form of subsidies, taxes, or regulations change market outcomes, and in competitive markets such changes distort allocations and can reduce economic efficiency. Does the financial safety net cause distortions? As discussed in Walter and Weinberg, in principle, the government could design guarantees that mimic market outcomes. Typically, however, government intervention arises from a desire to alter market outcomes. In the case of guarantees, this means either expanding coverage or underpricing relative to private market guarantees. Underpricing means that the guarantor collects fees that are less than the expected value of its obligations. This underpricing subsidizes risk taking.

Underpriced guarantees tend to shift resources away from activities that are not covered toward those that are. In that way, a government guarantee is similar to a direct subsidy paid to those engaged in a particular activity. A guarantee is different, however, in the way it affects attitudes toward risk. By assigning to the government part of the risk in the activities being financed, the safety net reduces market participants' willingness to control risk. Overprovision of guarantees, while not necessarily drawing resources into an activity, does shift risk preferences in a way similar to underpricing. In short, guarantees lead to expanded risk taking.

Our calculation of the size of the safety net does not represent a measure of the size of the distortions to the allocation of resources and risk taking. Such a measure would require knowledge of the extent of underpricing or overprovision of government guarantees. Thosewould be difficult to measure, especially the latter, since government provision often preempts private market activity. We nevertheless believe that the extent of distortions is directly related to the size of the safety net. Other things being equal, the greater the share of private liabilities protected by the government safety net, the more likely it is that government guarantees are extending beyond the level of protection that would be provided in a private market.

Why Have a Safety Net?

If the safety net is distortionary, why have one? Proponents of the financial safety net, especially as it applies to banks, often argue that private risksharing arrangements tend to disregard the systemic consequences of large losses borne by an individual or a small group of institutions. The idea here is that such losses might spill over and generate further losses caused, for example, by a contagious loss of investor confidence. …

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