Working Paper

The banking industry and the safety net subsidy

Abstract: Governments use monetary policies to counteract the effects of financial crises. In this paper we examine the subsidy that such \"safety net\" policies provide to the banking industry. Using a model of uncertainty-driven financial crises, we show that any monetary policy designed to maintain risky investment in the face of investor uncertainty (and thus promote economic growth and stability) will subsidize the banking industry. In addition, we show that the mere presence of a monetary authority willing to support a failing banking system in bad times subsidizes the banking industry, even if those bad times do not occur. A conditional bailout policy that does not extend equally to all financial institutions creates a greater subsidy for those institutions perceived as being \"close\" to the central bank, possibly giving these institutions a competitive advantage. Economic profits, in this model, are required to cover fixed costs of entry into the banking system.

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1999

Number: 1999-34