Defining the financial safety net: two dozen experts weigh in.

• Position: A SYMPOSIUM OF VIEWS

The 2007-08 subprime crisis has heightened the policy worlds interest in the makeup of financial markets. Financial institutions have set up off-balance-sheet vehicles as a means of disbursing and concealing risk, but to what extent do these off-balance-sheet vehicles during times of crisis fall under the central bank safety net? In the early stages of the subprime crisis, the Federal Reserve quickly made clear the off-balance-sheet vehicles of banks enjoyed safety net protection, but not those of non-bank financial institutions.

This brings up the issue of whether the collapse of a large American investment bank would be any less destructive to the macro economy than the failure of a commercial bank. In the United Kingdom, after initially refusing to bail out the mortgage bank Northern Rock, authorities now appear to have placed the safety net under all domestic financial institutions, which raises the question of why any U.S. non-bank financial institution wouldn't consider shifting its headquarters to London, given the promised protection by British taxpayers. Would the same taxpayers be willing to guarantee the entire world's non-bank financial institutions? Put another way, should U.S. taxpayers be asked to guarantee the financial activities of a Hong Kong trader using an American investment bank as a clearing broker?

How should the U.S. and global safety net be defined for the twenty-first century? Specifically, is the current system of off-balance-sheet vehicles inconsistent with the goal of greater financial transparency? Are reforms needed, and if so, which kind of reforms?

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GUILLERMO ORTIZ

Governor, Central Bank of Mexico, and Chairman, Bank for International Settlements Central Bank Governance Group

Central banks are last-resort lenders. Their role was pronounced by Walter Bagehot in his famous 1873 essay when he wrote that central banks should be prepared to lend freely against acceptable collateral but at penalty rates.

Central banks' options as last-resort lenders are influenced by each country's institutional arrangements. One size does not fit all. A central bank's lending procedures cannot be the same in a country with a faultily designed deposit insurance scheme as they are in one where depositors are less prone to panic runs.

The role of central banks has been changing through time. Their capacity to act covertly has been eroded by the widespread availability of information and the growing scrutiny of market participants. Their job as last-resort lenders has been further complicated by the stigma attached to borrowing from a central bank.

Central banks, as promoters of financial stability and managers of each country's ultimate settlement and clearing system, are also responsible for providing liquidity to financial markets. The aim is not to alleviate the situation of any particular institution, but rather to facilitate the normal functioning of markets when extraordinary events hinder operations.

Financial markets need certain amounts of liquidity to settle and clear operations. Under normal conditions, liquidity is provided by market participants themselves in the form of bilateral credit lines. These lines allow participants to settle their transactions without having to use large amounts of cash balances.

When certain shocks hit the markets, credit is usually squeezed. In this case, market participants need larger amounts of cash balances to settle their transactions, resulting in higher and more volatile interest rates. Under these circumstances, the role of a central bank, as manager of the ultimate settlement system, is to provide enough liquidity to prevent impairment of financial markets. Examples of extraordinary events abound, such as Black Monday in 1987, Y2K, and the terrorist attacks of September 11, 2001.

The fast growth of financial markets and the increasing number of participants with new and varying characteristics have exposed the former to a series of previously unknown shocks. Central banks have to take a more active role in mitigating liquidity squeezes, as recent events, which do not have a historic parallel, have shown.

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MALCOLM KNIGHT

General Manager and CEO, Bank for International Settlements, and former Senior Deputy Governor, Bank of Canada

A financial safety net is an instrument of public policy designed to mitigate the costs associated with stress-in private-sector financial institutions. Intervention of this sort always involves some element of moral hazard but can be justified when the costs to society of an unmitigated outcome exceed those borne by participants in the financial system itself. The moral hazard induced by the safety net reinforces the need for financial regulation and supervision.

Some safety net instruments are put in place before evidence of stress emerges. These include explicit deposit insurance schemes or explicit criteria for closing down financial institutions. Prior arrangements to speedily transfer essential functions of troubled banks to other existing or specially established banks, although less common, are another example of this.

Other safety net instruments are used when financial stress is already evident. These can include emergency lending assistance to individual institutions and generalized liquidity infusions. In extreme situations, public-sector intervention has taken the form of wholesale government guarantees for certain private-sector liabilities, nationalization of elements of the financial system, supervisory forbearance, or an explicit easing of monetary policy.

The less-well-developed measures are before a problem arises, the greater the likelihood of measures needing to be devised under stress once the problem strikes. Such measures conceived in extremis are more vulnerable to moral hazard, can be costly to governments, and can have significant side effects. The possibility of easier monetary policies generating excessive credit creation and unwarranted asset price increases is a case in point.

These considerations have two implications. First, greater efforts are required to ensure a resilient ex ante safety net structure. Second, if recourse to other forms of public-sector intervention proves to be costly, the management and shareholders of the financial firms responsible should be made to bear an appropriate cost in order to mitigate moral hazard effects.

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BARTON BIGGS

Managing Partner, Traxis Partners

There is no question in my mind that the failure of a large American investment bank would rock the world's financial markets and would be very destructive to the macro economy. The world could certainly live with one less investment bank, but there would be malignant contagion. It is not well known, but under the U.S. bankruptcy laws, a failed investment bank would have to liquidate the securities it held in margin accounts for customers to meet its creditors' demands. An investment bank with a major prime brokerage business (which all of them have) would thus trigger a cataclysmic financial panic as it closed its hedge fund clients' positions. Just the thought of such indiscriminate selling would terrify markets. Considering these circumstances, U.S. investment banks logically should shift their headquarters to London, and the British taxpayers should rebel.

I write as an owner of the shares of a major investment bank and one whose hedge fund has it as a prime broker. From my biased viewpoint, it seems to me that the major U.S. investment banks are "too big to fail" and should be under the protection of the Fed. The degree of leverage of their balance sheets should also be subject to Fed regulation including the size of their Level Three assets as a percent of equity capital.

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SAMUEL BRITTAN

Columnist, Financial Times

Why should there be a safety net for banks and not for the steel industry, textiles, or other victims of economic change? The cliche reply is that money, as the lubricant of the economic system, is "different." This might have had plausibility when there was a hard-and-fast line between banks and other financial institutions. Central bank safety nets could in principle be extended from deposit banks to investment banks. But there would be no shortage of other corporate bodies claiming similar services; and if we are not careful safety nets would be demanded for most of the economy, which would be either impossible or disastrous if attempted. As I write, the British authorities are trying to define their guarantee to Northern Rock depositors without a limitless spread of guarantees.

Ordinary citizens are entitled to a modern equivalent of keeping dollar bills or sterling notes under the mattress which avoids the physical hazards of such procedures. To this end Henry Simons, a Chicago economist writing in the 1930s and 1940s, proposed the creation of pure deposit-taking institutions ("hundred percent money") whose assets would have to be held in currency or Federal Reserve deposits ("A Positive Program for Laissez-Faire"). Other financial institutions, whether or not called banks, would carry on paying interest and looking for more profitable investments. Those using them would learn that higher returns came with higher risks. The idea is not as far-out as it seems, as it would be possible to build on the state-sponsored national savings institutions existing in several countries, for instance by providing for faster withdrawals and allowing checks to be written against them.

The immediate task for governments and central banks is to prevent a contraction of world demand without overdoing it and sowing the seeds of the next inflation. But this is also the time to take a longer-term look at the financial system to try to reduce the frequency and severity of monetary crunches.

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MARTIN MAYER

Nonresident Scholar in Economic Studies, Brookings Institution

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