The Federal Reserve acknowledges that more than half of all of the liabilities of firms in the U.S. financial sector are either implicitly or explicitly backed by the government:
The more we rely on government guarantees of private-sector financial liabilities as our main defense against financial market disruption, the more we must regulate private risk management to offset the adverse incentive effects of that safety net.
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Government guarantees of private debt – either explicit or implicit – can have profound effects on debtors’ and creditors’ incentives to appropriately price and manage risk exposures. These effects are likely to have been particularly acute for the large institutions that were at the heart of this crisis and viewed as too big to fail. Their creditors will see their own risks as at least partially reduced by the explicit or implicit government guarantees, and will therefore require less of a risk premium and impose fewer covenant restrictions than they otherwise would. Inexpensive debt financing will encourage an institution to seek greater leverage than it otherwise would, and increased leverage, in turn, makes an institution less averse to taking large risks, other things being equal.
Measuring the effects of the safety net on incentives for risk management is difficult. But measuring the safety net itself is possible. Research by Richmond Fed economists showed that in 1999 about 27 percent of all of the liabilities of firms in the U.S. financial sector were explicitly guaranteed by the federal government. By their estimate, another 18 percent enjoyed at least some implicit support, or were likely to be perceived by markets to have such support, so a total of 45 percent of financial sector liabilities had at least implicit government backing. This was a conservative estimate of implicit guarantees, consisting basically of the government-sponsored enterprises and the uninsured deposits of the largest banks. In the course of the current crisis, explicit guarantee programs have grown, for instance through the expansion of deposit insurance. An estimate of the implicit safety net guarantees would also no doubt be larger today, as we have seen protection temporarily extended to nondeposit creditors of banks and other financial institutions. So it seems likely that a substantially larger fraction of the financial sector is now operating under the effects of the safety net.
Choices in Financial Regulation, Remarks by Jeffrey Lacker, President, Federal Reserve Bank of Richmond, September 14, 2009, http://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2009/lacker_speech_20090914.cfm.
