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# IV. **The Safety Net and Supervision**<sup>**28**</sup>

The safety net-defimed broadly-has a bearing on the size and frequency of financial crises, the efficiency of institutions and general financial development. The design of the safety net relates to its necessary complement, i.e., supervision. The literature on safety nets for developing countries (including Kane (1999); Brock (1998); Garber (1997); Calomiris (1996); and Mishkin 1996) has focussed on the following issues:

- What are the main motivations for the safety net?

- What are the main components of a safety net? * What are the tradeoffs between the scope of a safety net and the effects of financial sector efficiency and incentives?

- What is the best design of a safety net, particularly regarding deposit insurance? * What are essential prerequisites for effective supervision and how these can best be achieved?

- * What are the supervisory issues arising from multiple financial services being provided through a financial conglomerate versus separate entities?

# 1. **Introduction**

There are two main motivations for a safety net: (i) systemic consequences of a run on one or more banks; and (ii) protection of depositors against the failure of individual banks.

The systemic consequences' motivation arise as banks are considered to be special in two ways. First, they provide credit to other firms and manage the flow of payments throughout the economy. Disruptions in the credit supply and a breakdown of the payment system may have large spillover effects for the rest of the economy. Bank failures or losses in capital can lead to contractions in aggregate bank credit with large social costs to bank borrowers outside the banking system. Second, banks are especially prone to failure due to their high leverage, shortterm funding structure and the fact that the value of their assets is difficult to discern. This information problem coupled with banks' demandable debt and sequential servicing feature (Calomiris and Kahn) (depositor withdrawals are serviced on a first come first serve basis and not on a pro rata basis), makes banking inherently fragile and susceptible to runs (Diamond and Dybvig 19830 where depositors overreact to information and withdraw funds even from (solvent) banks. Thus, small shocks to solvency may lead to costly systemic runs, where depositors possibly overreact to information and force the closure of solvent institutions.

The protection of small depositors' motivation arises because the combination of asymmetric information and limited liability structures creates room for the abuse of depositors by bank shareholders and managers. As small depositors lack the ability to monitor at low costs, bank supervisors, as the representatives of (small) depositors, will aim to prevent failure of individual financial institutions, which involves the use of the safety net.

The two main mechanisms by which authorities try to deal with these concerns are lender of last resort and deposit insurance facilities (besides the general regulatory and supervisory framnework). Lender of last resort facilities are aimed at providing (solvent) banks that face rapid 2 S The following section draws heavily on Demirguc-Kunt, 1999; Demirguc-Kunt and Kane 1997; and Scott 1994 and 1995.