Building an incentive-compatible safety net

Bank safety nets, originally proposed as a means of stabilizing financial systems, have become an important destabilizing influence. Government protection of bank debts encourages banks to undertake excessive risk, particularly in response to adverse shocks to asset values. Reforms that would remove the destabilizing moral hazard consequences of government protection are considered, both from the perspective of economic desirability and political feasibility. Requiring banks to maintain a minimal proportion of subordinated debt finance, and restricting the means by which government recapitalization of insolvent banks occurs are the central features of promising reforms to the safety net. (C) 1999 Elsevier Science B.V. All rights reserved.