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Economic Brief
NOVEMBER 2009, EB09-11

Rolling Back the
financial safety Net
By Robert l. hetzel and stephen slivinski

The expansion of the federal financial
safety net has increased the incentives
for financial firms to take on more risk
than they would have otherwise.
Yet current regulatory reform proposals
do not address this root cause of
financial instability. Sharply curtailing
the financial safety net is a necessary step
to achieve enhanced market discipline.

The most recent expansion of the financial safety net that protects
debtholders and depositors of financial institutions from losses began on
March 15, 2008, with the bailout of Bear Stearns’creditors. The New York
Fed assumed the risk of loss for $30 billion (later reduced to $29 billion)
of assets held in the portfolio of the investment bank as enticement to
JPMorgan Chase to acquire it. Later, the Fed opened the discount
window to banks and financial institutions that did not formerly have
access to Fed credit.
The rationale for this and subsequent extensions of the safety net was
the minimization of“systemic risk”– namely, a reduction in the threat of
a cascading series of defaults brought about by wholesale withdrawal of
investors from money markets and depositors from banks. Yet economists today recognize that financial safety nets can create a“moral
hazard”– that is, an increased incentive to take risks.1 Given the twin
goals of financial stability and mitigation of moral hazard, what financial
regulatory regime should emerge as a successor to the current one?
Any proposal must address the consensus that financial institutions took
on excessive risk in the period from 2003 to the summer of 2007. These
institutions did so through the use of leverage that involved borrowing
short-term and low-cost funds to invest in long-term, illiquid, and risky
assets. Any new financial regime must limit this sort of risk-taking.
But should that limitation come from increased oversight by government
regulators or should it come from the enhanced market discipline that
would follow from sharply curtailing the financial safety net? One of
the authors of this Economic Brief, Robert Hetzel, argues for the latter
alternative in the spring 2009 issue of the Federal Reserve Bank of
Richmond Economic Quarterly.2
Myths Of fiNaNcial MaRkEt fRagility
A strong case can be made that the financial system would not be
inherently fragile in the absence of an extensive financial safety net.
History offers evidence that financial markets become fragile mainly
because the financial safety net exacerbates risk-taking.

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There is ample historical analysis of bank runs before the establishment
of deposit insurance in 1934 and the subsequent expansion of the
financial safety net. In those studies, bank runs were found to have
originated with banks that were actually insolvent. Before deposit

insurance, market discipline was effective in closing banks promptly
enough to avoid significant losses to depositors. Moreover, the failures
that did occur resulted not from“panics”but rather from well-founded
withdrawals from banks whose assets suffered declines in value because
of aggregate disturbances. An example of such a disturbance was the
failure in the 1840s of Indiana banks that held the bonds used to finance
the canals rendered unprofitable by the advent of the railroad.3
From the end of the Civil War to the end of World War I, bank failures
were relatively few in number and resulted only in small losses because
the fear of large losses by both shareholders and depositors were
motivated by significant market discipline. This resulted in high capital
ratios and prompt closure of troubled banks. Even in the 1920s, when
bank failures became more common, runs were uncommon and, when
they did occur, funds were re-deposited in other banks.4
The waves of Depression-era bank failures before deposit insurance
reflected fundamental concerns about banks’solvency as opposed to
depositor panic fueled by incorrect information about the actual health
of banks.5 In an investigation of all Fed member bank failures, apart from
January and February 1933, economists Charles Calomiris of Columbia
University and Joseph Mason of Louisiana State University found“no
evidence that bank failures were induced by a national banking panic.”6
thE adVERsE iNcENtiVEs Of aN ExpaNdiNg safEty NEt
In theory, regulators could draw a clear line demarcating the boundaries
of the financial safety net. Regulators could limit risk-taking of banking
institutions and require high capital ratios. Yet, you could also expect
that creditors of uninsured institutions who have their own money at
risk would also make similar demands. This latter form of pressure can
be described as“market regulation of risk-taking.”
A tension arises when regulators cannot draw a credible line separating
the insured from the uninsured. Institutions on the uninsured side have
an incentive to find ways to retain the cheap funds guaranteed by the
perception that they are on the insured side while acquiring the risky
asset portfolios with high returns of institutions on the uninsured side.
The implicit subsidy to a financial institution from the protection afforded
by the financial safety net rises with the riskiness of the institution’s asset
portfolio. Thus, the current financial safety net provides an incentive to
banks to acquire risky assets offering a high rate of return without having
to increase their capital buffer commensurately.
Government regulation of risk-taking has not sufficiently substituted
for the market regulation that would occur if bank creditors bore the full
effects of risky behavior by those banks. At least since the 1980s and the
bailout of the savings and loan institutions in the United States, the

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expanding financial safety net has undercut the market regulation of
risk-taking. The protection provided by deposit insurance, by the Fed’s
discretionary discount window lending, and the federal government’s
assumption that some institutions are simply“too big to fail,”have
effectively allowed banks to have access to funds that do not become
more costly as the bank’s asset portfolio becomes riskier.
The prevailing assumption in policymaking circles has been that government does not need an explicit stance with respect to bank bailouts or
to credibly commit to a specific course of action. A term that has been
used to describe current policy is“constructive ambiguity.”Although
this characterization in principle acknowledges that regulators have the
discretion to not bail out all bank creditors, the prevailing practice of
regulators – namely, their past actions to prevent uninsured depositors
and debtholders from incurring losses in the event of a bank or thrift
failure – limits the incentives for market participants to monitor risk-taking by creditors.
a pROpOsal tO ROll Back thE fiNaNcial safEty NEt
Rolling back the financial safety net depends upon the ability of
government to commit credibly to allowing creditors to take losses and
thus encourage market-based regulation of risk. That requires taking the
bailout option out of the hands of regulators.
The feasibility of any such proposal requires thinking about what the
financial system might look like with a severely limited safety net. We
can make some plausible assumptions. The large amount of investment
in government and prime money market mutual funds holding shortterm government securities and prime commercial paper is evidence of
the extensive demand by investors for debt instruments that are both
liquid and safe. In the absence of the safety net, these investors would
constitute a huge market for financial institutions marketing themselves
as safe because of high capital ratios and a diversified asset portfolio of
high grade loans and securities.
In other words, the market could create a parallel narrow banking system. These institutions would constitute a core of run-proof institutions
into which, in the event of a financial panic, creditors would deposit the
funds they withdrew from the risky institutions. Yes, depositors at the
safe banks would earn a low rate of return, but they, not the taxpayer,
would then be the ones paying for financial stability.
To make such a system viable, changes to the current regulatory regime
would need to be made. First the government would commit to not bail
out the creditors of financial institutions, especially those of large banks.
Instead, if a bank experiences a run, the chartering regulator would put it
into conservatorship. Under conservatorship, regulators would assume

a majority of the seats on the bank’s board of directors.The directors would
then decide whether to sell, liquidate, break up, or rehabilitate the bank.
By law, this conservatorship should eliminate the value of equity and
impose an immediate loss on all holders of debt and holders of uninsured
deposits, while leaving the remainder of these instruments free for

Two related questions must also be asked. First, in the absence of the risktaking induced by a generous safety net, would market discipline produce
contracts and capital levels sufficient to protect all but insolvent banks
from runs? And, second, could regulators place the actually insolvent banks
into conservatorship (with mandatory losses imposed on debtors and large
depositors) without destabilizing the remainder of the financial system?
The historical record leads us to answer those questions in the affirmative.

Second, a mechanism should be put in place that encourages banks
and creditors to monitor themselves and each other.7 The federal
government could divide banks into groups – for instance, the ten
largest could be put into one group, the next ten largest in another
group, and so on. The individual banks would pay deposit premia into a
fund set up for that group in particular. The banks would also be subject
to an assessment to replenish the fund if a bank in their group required
recapitalization as a result of a bank run, even after the mandated“haircuts” for creditors. Each group would have an advisory board that would
make recommendations to the Federal Deposit Insurance Corporation
(FDIC) for its group about regulating risk, setting the level of the insurance premia, and designing a risk-based insurance levy. The FDIC would
set individual group capital standards and other regulations to limit

Robert l. hetzel is a senior economist and policy advisor in the
Research department of the federal Reserve Bank of Richmond. stephen slivinski is senior editor of the Bank’s quarterly
magazine, Region Focus.
1 Steelman, Aaron, and John A. Weinberg.“The Financial Crisis: Toward an Explanation and Policy
Response.”Federal Reserve Bank of Richmond 2008 Annual Report, pp. 5-17; and Goodfriend,
Marvin, and Jeffrey M. Lacker.“Limited Commitment and Central Bank Lending.”Federal Reserve
Bank of Richmond Economic Quarterly, Fall 1999, vol. 85, no. 4, pp. 1-27.

Hetzel, Robert L.“Should Increased Regulation of Bank Risk-Taking Come from Regulators or
from the Market?”Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009, vol. 95,
no. 2, pp. 161-200.


This system would create an incentive for banks in the group to lobby
the FDIC to prevent excessive risk-taking by the other banks in their
group. As a check, the public would see the cost of the subordinated
debt of each group relative to that of the others. At the same time, the
large number of banks in the group would discourage collusion. In the
event of a run on a solvent bank, the other banks in the group would
possess the information needed to lend to the threatened bank to limit
the run just as banks did in the pre-Fed era. A demonstrated willingness
of banks to support each other would inspire depositor confidence, too.

Rolnick, Arthur J., and Warren E. Weber. “The Causes of Free Bank Failures: A Detailed Examination.”
Journal of Monetary Economics, November 1984, vol. 14, no. 3, pp. 267-291; and Dwyer, Gerald P.
“Wildcat Banking, Banking Panics, and Free Banking in the United States.”Federal Reserve Bank
of Atlanta Economic Review, December 1996, vol. 81, nos. 3-6, pp. 1-20.


Benston, George J., Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane, and George G. Kaufman.
Perspectives on Safe & Sound Banking. Cambridge, Mass.: MIT Press, 1986; Benston, George J., and
George G. Kaufman.“Is the Banking and Payments System Fragile?”Journal of Financial Services
Research, December 1992, vol. 9, nos. 3-4, pp. 209-240; Goodfriend, Marvin, and Robert G. King.
“Financial Deregulation, Monetary Policy, and Central Banking.”Federal Reserve Bank of Richmond
Economic Review, May/June 1988, vol. 74, no. 3, pp. 3-22; Kaufman, George G.“Banking Risk in
Historical Perspective.”In George G. Kaufman (ed.), Research in Financial Services, Vol. 1. Greenwich,
Conn.: JAI Press 1989, p. 151–64; and Kaufman, George G.“Bank Contagion: A Review of the Theory
and Evidence.”Journal of Financial Services Research, April 1994, vol. 8, no. 4, pp. 123-150.


Finally, an essential step to establishing a more market-based regulatory arrangement is terminating the legal authority of the Fed to make
discount window loans. Instead of parceling out credit to specific firms
or sectors, the Fed would resort to its traditional tools of providing the
entire market with liquidity by undertaking purchases of securities
through its open market operations.8 It could also use its new ability to
pay interest on bank reserves to maintain its funds rate target.
Government regulation of risk-taking has proven not to be a suitable
substitute for a market-based system of regulation. Yet many reform
proposals currently debated suggest more government regulation is
necessary, not less.

Calomiris, Charles W., and Joseph R. Mason. “Contagion and Bank Failures During the Great
Depression: The June 1932 Chicago Banking Panic.” American Economic Review, December 1997,
vol. 87, no. 5, pp. 863-883.


Calomiris, Charles W., and Joseph R. Mason. “Fundamentals, Panics, and Bank Distress During
the Depression.” American Economic Review, December 2003, vol. 93, no. 5, pp. 1615-1647.


This proposal is an elaboration of the ideas in Calomiris, Charles W. “Deposit Insurance:
Lessons from the Record.” Federal Reserve Bank of Chicago Economic Perspectives, May 1989,
vol. 13, no. 3, pp. 10-30.


For an analysis of how the Federal Reserve could eliminate the discount window, yet continue to
provide adequate liquidity to the market, see Goodfriend, Marvin, and Robert G. King. “Financial
Deregulation, Monetary Policy, and Central Banking.” Federal Reserve Bank of Richmond Economic
Review, vol. 74, no. 3, May/June 1988, pp. 3-22.

The views expressed in this article are those of the authors and not
necessarily those of the Federal Reserve Bank of Richmond or the Federal
Reserve System.

Any proposal to fix the current regulatory regime must first cope with the
idea that capital markets may not be as inherently fragile as some think.

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