Aspects of Financial Safety Nets
Financial safety nets consist of three main elements: (a) a framework for liquidity support, (b) deposit insurance plus investor and policyholder protection schemes, and (c) crisis management policies. Each element of the safety net is designed to prevent situations in which the failure or potential failure of individual financial institutions disrupts the intermediation function of financial markets and, thus, the broader economic activity. Facilities for liquidity support attempt to prevent liquidity difficulties in one institution (or market) from being transmitted throughout the financial system. Deposit insurance and other protection schemes are designed to provide confidence to the least-informed depositors and investors with respect to the safety of their funds and thereby avoid spillovers from runs. Crisis management policies are established to minimize the disruption caused by widespread difficulties in the financial sector and thus avoid those difficulties from spilling over into broader economic activity. Therefore, in assessing the adequacy of the financial sector safety net, all three elements, including their legal underpinnings and their interconnections, should be considered.
