Stretching the Financial Safety Net to Its Breaking Point

Abstract

During a financial crisis, the immediate benefits of rescuing insolvent lenders and their creditors with subsidized loans and blanket guarantees tempts regulators and politicians to ignore or downplay the taxpayer burdens that blanket rescues entail. This anti-egalitarian policy strategy would seem doubly attractive to the central bank responsible de facto for supporting the world’s leading reserve currency. In fact, during the Great Financial Crisis, Federal Reserve officials used currency swaps and other nontransparent bailout programs to rescue major foreign (especially European) banks and their worldwide creditors from spreading distress. The extent to which top officials patted each other on the back for the stabilizing effects of this global bailout program encouraged private counterparties and foreign government officials to see the Federal Reserve System -- then and since -- as the global rescue party of last resort. This paper argues that the continuing widespread belief that the Fed will not allow any major megabank to fail has enabled authorities in other nations to leave zombie banks unresolved and emboldened them to expand their own system of guarantees, in many cases beyond their fiscal capacity to pay for them.