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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page The Banking Industry and the Safety Net Subsidy
Andreas Lehnert and 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.

Keywords: Knightian uncertainty, safety-net subsidy, monetary and fiscal policy

Full paper (124 KB PDF) | Full paper (148 KB Postscript)

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Last update: September 8, 1999