Importance of financial safety networks
Importance of financial safety networks
Financial institutions, especially deposit taking ones such as banks, supply their resources from the public. Therefore their bankruptcy affects a considerable number of people.
Therefore maintaining financial soundness of the financial institutions means protecting depositors against dangers resulting from incorrect performance of the mentioned institutions.
History of forming financial safety networks
First steps to form financial safety networks could be linked to the big economical and banking crisis.
For example, establishment the Federal Reserve in the United States after the 1907 crisis. Establishment of the FDIC (Federal Deposit Insurance Corporation) is also a result of the 1930s big crisis.
In the current decade also approval of articles such as Glass-Stegel has limited financial institutions to considerable supervision.
The logic behind designing financial safety network
Three major steps exist in designing financial safety network:
First step: Crisis prevention in micro and macro level.
Second step: Protecting sound financial institutions that are facing shortage of liquidity.
Third step: Resolving institutions that are facing insolvency and bankruptcy together with protecting the depositors.
First step: Crisis prevention (legislation and supervision)
This step is accomplished through developing prudential regulations and supervision.
In some countries performing this duty is borne by an independent institution (independent from the central bank). For example, in Australia, this responsibility is borne by the Australian Prudential Regulation Authority (APRA).
In some countries such as Iran also, a major part of this duty is borne by the central bank.
Second step: Protecting sound financial institutions that are facing shortage of liquidity.
Traditionally, In addition to codification and execution of monetary policy, central bank also takes this step as the lender of last resort.
Central bank’s protection only covers institutions that have operated according to banking standards and have enough valuable assets available; but in short term face shortage of liquidity.
Obviously, the above mentioned protection takes place in the frame work of rules and regulations.
Third step: Resolving institutions that are facing insolvency and bankruptcy together with protecting the depositors.
Traditionally, this step has been up to deposit insurance funds.
On the one side, these funds insure deposits of the public up to a certain limit and on the other side; they have the responsibility of conducting resolution on institutions facing insolvency and bankruptcy.
In some counties deposit insurance fund is independent but in some others it depends on the banking supervision and legislative institution. For example, in Australia, deposit guarantee plan is part of the APRA’s duties.
Development in financial safety networks
Financial crisis of the 2007-2009 showed that a fourth step should also be added to the above mentioned ones:
Fourth step: financial bailout of institutions having systemic importance.
By adding this step, instead of financial safety networks, financial stability networks became the talked about subjects.
The goal of financial stability networks is not only the protection of depositors, but also maintaining stability in the country’s financial and economic system as a whole is their major objective.
Fourth step: financial bailout of institutions having systemic importance.
Financial crisis of the 2007-2009 showed that sometimes systemic risk grows in an unprecedented manner in the entire financial system. In such situation bankrupting systemically important institutions that are facing insolvency may cause instability in the whole financial system of the country in form of a domino effect. In such conditions it is no longer possible to make use of the third step (the traditional role of deposit guarantee fund and recovery). For this reason, in such crisis, governments (ministry of finance / Treasury) acted on bailing out systemically important institutions. Governments that were known as the fourth pillar of the financial stability network bailed out such institutions by injecting liquid capital into them and by other possible methods. In other developed countries also similar actions were taken in order to bailout systemically important institutions.
