Vol. 2001-9
The Safety Net: Myths, Perceptions, and History
Note This Report is appearing much later than scheduled. I have no apologies. The monstrous attack on the United States on September 11 made it impossible to consider, calmly and analytically, what was happening in banking. It all seemed trivial or meaningless. Now the world has come back into focus for me and, I am certain, for millions of others. But I fear that it will never be quite the same world again.
Each year, at about this time, I pull together letters and memoranda from readers commenting on various of our reports issued during the past ten months or so. I was engaged in this task when it occurred to me that most of the comments I had received were variations on a single theme: how well or poorly the federal government was doing to assure the stability of the banking and financial system. Financial system stability is the assumed purpose of a Safety Net, hence the title I selected. Most fascinating public policy issues are, at the same time, Safety Net issues, and a knowledge of their origins often facilitates understanding. I suppose this is saying nothing more than that history does count, something that I have always believed.
The Safety Net has been a popular subject recently for those who deal with public policy issues affecting banking and finance. In fact, the Federal Reserve Bank of Chicago made it the theme of its prestigious annual conference on bank structure and competition last May: “The Financial Safety Net: Costs, Benefits, and Implications For Regulation.” Not surprisingly, the conference generated an impressive group of articles, and I am looking forward to the publication of the complete proceedings.
It is apparent, at least from my reading, that no authoritative list of the components of the Safety Net is available. It all seems to depend on who is doing the writing. Thus far, the federal government’s deposit insurance program, administered by the FDIC, is the only component included on just about every list. The Federal Reserve’s lender-of-last-resort power is a close second. Two excellent recent articles on the Safety Net are illustrative.
One was by Bert Ely: “The Federal Financial Sector Safety Net,” prepared for, and published last March by, The Financial Services Roundtable. Ely views as the purpose of the Safety Net the need to assure U.S. financial stability. He therefore includes among its components major federal programs intended to protect creditors of financial institutions from the insolvency of such institutions. Obviously, the major component of the Safety Net is federal deposit insurance, but also included are such other components as the Securities Investor Protection Corporation (SIPC), government sponsored institutions such as Fannie Mae and Freddie Mac, federal disaster relief, and the possible federal chartering of insurance companies, along with the possibility of protection of owners of insurance policies against insurance company failures. In addition, Ely includes the Federal Reserve’s lender-of-last-resort power, together with its ability to inject liquidity into financial markets in times of crisis, and its efforts to assure uninterrupted operation of the payments system. (Bert Ely, Ely & Company, Inc., Alexandria, Virginia, March, 2001)
The second paper titled “The New Safety Net,” by George G. Kaufman and Peter J. Wallison, appeared in the “Summer, 2001” issue of Regulation. (Kaufman’s affiliation is with Loyola University Chicago, and he is co-chairman of the Shadow Financial Regulatory Committee; Wallison’s affiliations include the American Enterprise Institute (AEI), Washington, DC where he is Director of AEI’s Financial Deregulation Project, and with the U.S. Council on Foreign Relations). The Kaufman-Wallison view of the Safety Net is much narrower than Ely’s, largely because it relates only to the “banking safety net.” The authors see the Net as having just three components: deposit insurance provided by the FDIC, lender-of-last-resort powers of the Federal Reserve, and the Fed’s responsibility for uninterrupted operations of the payments system. However, merely by including the first two of the three items noted above, federal deposit insurance and Federal Reserve lending authority, they still cast a fairly broad net so far as policy issues are concerned.
Personally, I have always viewed Federal Reserve lending functions as a traditional central bank power, one that does not fit naturally with deposit insurance. And I have similar difficulties thinking of the Fed’s interest in the smooth functioning of the payments system as anything other than a central bank matter, much of which I have always assumed could as well be handled by private companies. In other words, I consider the terms “federal deposit insurance” and “federal safety net” as synonymous -- which I have a hunch many people do --with the latter (safety net) invented to give the impression that there is something here more grand than deposit insurance. This is not unusual. An amusing effort of this kind was made by Fed Chairman Alan Greenspan. During the debate with the Treasury over bank modernization legislation in 1997-99 and in the course of making the case for the superiority of the Federal Reserve as a regulator, he argued that “the bank holding company organizational structure has, on balance, provided an effective means of limiting the use of the sovereign credit subsidy by other parts of the banking organization.” By “sovereign credit subsidy” he meant federal deposit insurance! (See Key Banking Issues in the New Millennium, CHG Consulting, Inc., 1999, pp. 61-62)
Bottom line, I do not feel constrained to limit discussion in the sections that follow to my own view of what seems the most logical definition on the Safety Net. All views have some reason for acceptance. Perhaps, after all, it is simply a matter of taste.
The “topics agenda” for this Report was largely established by various letters, memoranda, and articles, received from readers, which seemed to me to be related to the Safety Net. Section I contains a number of comments on our last report (Vol. 2001-8), in which I was quite critical of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The comments should, for the most part, bring comfort to the supporters of that legislation. I should note that reports dealing with communications from readers are not used to reargue issues but simply to offer interesting and different views. I have only added, where I thought appropriate, some historical background. Thus readers who want a full discussion of the problems with FDICIA as I see them might wish to consult Vol. 1994-4 (“Reflections on the Origins of FDICIA”), (“Other Voices, Other Views”) Contains an article responding to my criticism, written by the principal academic architects of FDICIA. Complementary copies are available for those whose files are not complete or for new readers.
Sections II and III contain, respectively, observations on the Federal Reserve’s “lender-of-last-resort” authority (in Section II) and the scope of deposit insurance coverage (Section III). Both are key components of many Safety Nets. The first (lender-of-last-resort) has a long and, somewhat surprising history, dating back well before the receipt of this power by the Federal Reserve. As for insurance coverage, it is a “live” issue today, not only because of congressional interest but because it was one of the major points raised in the FDIC’s study of possible deposit insurance reforms.
Section IV contains what I believe is a particularly interesting comment on what is probably a new component of the Safety Net, namely, bank capital regulation by the federal government. It deals with some history that had been ignored in our Report on this subject (Vol. 2001-5&6).
Section V offers a few concluding observations.