Book Description

October 1998 Three principles that should govern the safety net for a country's financial system, altering bank behavior and deepening financial intermediation by shifting some risk to the government. Well-designed bank safety nets should alter bank behavior and deepen financial intermediation by shifting some risk to the government. It is often said that the best safety net for a financial system is one that makes market participants behave as if the safety net did not exist. Brock examines issues associated with safety nets for financial systems in small open economies such as those in Latin America. He stresses three principles that should guide the design and operations of a financial system safety net: * Safety nets should strengthen rather than supplant private capital, monitoring, and closure mechanisms. The presence of asymmetric information gives borrowers, bankers, and depositors incentives to voluntarily impose capital requirements, monitoring arrangements, and contractual provisions for the closure or recapitalization of firms and banks. Government regulations or safety net provisions should be designed to work in harmony with the incentives private agents already face. * Safety nets must take into account both aggregate risk and idiosyncratic risk. In particular, good safety nets must be designed to take into account large but infrequent macroeconomic shocks as well as to encourage prudential bank behavior during normal times. * Safety net design should be grounded in the historical and institutional framework of any given country. Safety nets evolve over time and must allow for problems that have existed for a long time-but must also take into account current political pressures and today's generally higher expectations about the government's ability to insure the financial system against aggregate shocks. This paper-a product of Finance, Development Research Group-is part of a larger effort in the group to study the role of incentives in finance. The author may be contacted at [email protected].