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The banking industry and the safety net subsidy

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  • Andreas Lehnert
  • Wayne Passmore

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.

Suggested Citation

  • Andreas Lehnert & Wayne Passmore, 1999. "The banking industry and the safety net subsidy," Finance and Economics Discussion Series 1999-34, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:1999-34
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    References listed on IDEAS

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    1. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    2. Andreas Lehnert & Wayne Passmore, 1999. "Pricing systemic crises: monetary and fiscal policy when savers are uncertain," Finance and Economics Discussion Series 1999-33, Board of Governors of the Federal Reserve System (U.S.).
    3. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    4. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
    5. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
    6. Myron L. Kwast & Wayne Passmore, 1998. "The subsidy provided by the federal safety net: theory and measurement," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
    7. Myron Kwast & S. Passmore, 1999. "The Subsidy Provided by the Federal Safety Net: Theory and Evidence," Journal of Financial Services Research, Springer;Western Finance Association, vol. 16(2), pages 125-145, December.
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    Keywords

    Monetary policy ; Banks and banking;

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