Defining the financial safety net: two dozen experts weigh in

International Economy, The, Wntr, 2008

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.