Financial Modernization: Implications for the Safety Net - Thomas M. Hoenig

• Citation: Vol. 49 No. 3
• Publication year: 1998

Financial Modernization: Implications for the Safety Net

Remarks by

Thomas M. Hoenig, President

Federal Reserve Bank of

Kansas City

Kansas City, Missouri^*

It is a pleasure to be here today as part of this panel on deposit insurance and financial modernization. Over the past twenty years, the world of finance has changed dramatically. During this period, we have seen phenomenal growth of new types of securities and derivatives markets, the globalization of finance and capital flows, and a blurring of the distinction between banks and other financial intermediaries.

These changes in financial markets have led to public debate among Congress, financial regulators, and financial industry participants about the appropriate role for banks, the so-called "financial modernization" debate. Much of this discussion has centered on the question of whether we should expand bank powers. I believe, however, that this question is not very useful to us as policymakers. Modernization and expanded powers are clearly necessary to allow banks to adapt to the changing financial world. In my view, a more relevant question is "how does the expansion of bank powers affect the exposure of the deposit insurance system and the other components of the safety net?"

The main point I want to make is that the path that banks are allowed to take in expanding their powers has important implications for the exposure of the safety net. In my remarks this morning, I would like to address four questions. First, why do we need a safety net? Second, why should we be concerned about extending the safety net? Third, in light of concerns about the structure of the safety net, is it feasible to reform the safety net? Finally, how does the approach to financial modernization affect the exposure of the safety net?

I. Why Do We Need a Safety Net?

Let me begin by defining what I mean by the safety net. The component of the safety net that receives the most attention is, of course, deposit insurance. The safety net, however, also includes the Federal Reserve's lender of last resort function and guaranteed final settlement on Fedwire, the Federal Reserve's large dollar interbank settlement system. As we think about the impact of new activities on the exposure of the safety net, I think it is important that we keep all three components in mind.

The safety net for the banking system has been put in place because of the unique role that banks play in the financial system—that is because banks are, and will continue to be thought of as, "special." Banking is special because, unlike other industries, disruptions in certain banking activities have negative external effects that extend beyond banking into other sectors of the economy. Indeed, banking problems can have a wide-ranging impact on overall economic activity. To limit the negative externalities associated with banking problems, most countries have chosen not to leave the fate of the banking industry solely in the hands of the market...