By Charles W. Calomiris, AEI Press, December 1997

The financial safety net constructed in the 1930s--in which government absorbs the risk of private bank defaults--may be the single most destabilizing influence in the financial system. According to the author of this volume, government policies to stabilize the banking system by insuring deposits create perverse incentives by protecting weak institutions from the discipline of the market. The author argues that the efforts of Chile, Argentina, and other countries to reform their banking systems provide useful lessons to the United States and other countries about ways to introduce private market discipline into government deposit insurance.

The Postmodern Bank Safety Net is one in a series of new AEI studies on subjects relating to the deregulation of financial markets. The series will focus on the regulation of the new multiproduct financial services firm; the costs and benefits of the government safety net; pricing and access for banks and nonbanks; globalization and the level playing field; mutual fund regulation; electronic commerce; securities markets; and corporate governance.

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Federal deposit insurance may be "the single most destabilizing influence in the financial system," says economist Charles W. Calomiris in a new study published by AEI.  Market discipline provides a better bank safety net than government insurance, he concludes.

The Postmodern Bank Safety Net: Lessons from Developed and Developing Economies(AEI Press; December 19, 1997) shows how government deposit insurance subsidizes the risks taken by banks.  Weak banks deliberately and sometimes with impunity take on greater risks than they can afford.

Undue risk-taking would not be tolerated were private market discipline brought to bear on banks, Calomiris argues.  Market discipline would place the regulatory burden on sophisticated market participants with their own money at stake--a bank would survive only if it had investors, and those investors would be willing to risk their money only if they were able to evaluate the bank's risk.

Currently, banks that hide loan losses can avoid paying increased deposit insurance costs.  At the same time, Calomiris says, government regulators lack strong incentive to determine the true risk characteristics of bank assets--government regulators do not have their own money at stake and they face political pressure to maintain the credit supply.

The results can be calamitous.  In the 1970s and 1980s the Farm Credit System was increasingly willing to lend against questionable collateral while private banks withdrew from the market as lending risk increased.  The system failed, gripping U.S. farmers in a debt crisis.  Similarly, the savings and loan failures and the oil-related bank collapses in Texas and Oklahoma of the 19080s can be attributed to the failure of the bank safety net.  And Chile, Mexico, and Japan have suffered financial collapses because their governments protected banks from self-inflicted losses.

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