Financial Safety Nets: Reconstructing and Modeling a Policymaking Metaphor

Abstract

This paper explains that financial safety nets exist because of difficulties in enforcing contracts and shows that elements of deposit-insurance schemes differ substantially across countries. It argues that differences in the design of financial safety nets correlate significantly with differences in the informational and contracting environments of individual countries and that a country's GDP per capita is correlated with proxies for a country's level of: (1) informational transparency, (2) contract enforcement and deterrent rights, and (3) accountability for safety net officials. The analysis portrays deposit insurance as a part of a country's larger safety net and contracting environment. This means that there is no universal method for preventing and resolving banking problems and that the structure of a country's safety net should evolve over time with changes in private and government regulators' capacity for: valuing financial institutions, for disciplining risk taking and resolving insolvency promptly, and for being held accountable for how well they perform these tasks.