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Designing financial safety nets to fit country circumstances

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  • Kane, Edward J.

Abstract

The author explains how differences in the informational and contracting environments of countries affect the optimal design of their financial safety nets and their optimal strategies for managing financial crises. He explains how to design and operate safety nets at minimum cost to taxpayers and well-managed banks in countries whose informational and contracting technologies differ. His basic premise is that optimal regulation is not a one-size-fits-all proposition. A country's safety net should be transparent, deterrent to too much risk-taking, and accountable, but the author shows large differences across countries in the transparency and deterrence banks afford their depositors, highlighting why the design of safety nets must allow for differences in the enforceability of private contracts. The weaker a country's informational, ethical, and corporate governance environment, the more a wholly governmental system of explicit deposit guarantees is apt to undermine bank safety and stability. How a country's safety net evolves depends on the ability of the private and public sectors to value banks, discipline risk-taking, and resolve financial difficulties promptly. And political accountability is essential if the public part of these tasks is to evolve effectively and efficiently. As a rule of thumb, safety-net managers should avoid either subsidizing or taxing bank risk-taking, says the author. Even if analysts could formulate a beneficial tax or subsidy rule, it is unlikely that channeling the effect through a government-run deposit insurance system that fails to account publicly for the size of taxpayers'stake could improve upon more straightforward arrangements.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2453.

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Date of creation: 30 Sep 2000
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Handle: RePEc:wbk:wbrwps:2453

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Keywords: Financial Intermediation; Banks&Banking Reform; Insurance&Risk Mitigation; Labor Policies; Payment Systems&Infrastructure; Banks&Banking Reform; Financial Intermediation; Insurance&Risk Mitigation; Financial Crisis Management&Restructuring; Environmental Economics&Policies;

References

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  1. Anna J. Schwartz, 1999. "Is There a Need for an International Lender of Last Resort?," Cato Journal, Cato Journal, Cato Institute, vol. 19(1), pages 1-6, Spring/Su.
  2. Rafael La Porta & Florencio Lopez-De-Silanes & Andrei Shleifer, 2002. "Government Ownership of Banks," Journal of Finance, American Finance Association, vol. 57(1), pages 265-301, 02.
  3. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  4. Talley, Samuel H. & Mas, Ignacio, 1990. "Deposit insurance in developing countries," Policy Research Working Paper Series 548, The World Bank.
  5. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  6. Asli Demirguc-Kunt & Enrica Detragiache, 2000. "Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation," Econometric Society World Congress 2000 Contributed Papers 1751, Econometric Society.
  7. Cukierman, Alex & Webb, Steven B & Neyapti, Bilin, 1992. "Measuring the Independence of Central Banks and Its Effect on Policy Outcomes," World Bank Economic Review, World Bank Group, vol. 6(3), pages 353-98, September.
  8. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  9. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
  10. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
  11. Black, Fischer & Miller, Merton H & Posner, Richard A, 1978. "An Approach to the Regulation of Bank Holding Companies," The Journal of Business, University of Chicago Press, vol. 51(3), pages 379-412, July.
  12. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
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