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day, however, deposit insurance and the federal safety net

are important factors to consider.

Stability and the Safety Net

An important argument made for bank regulation and, in

particular, against broadening bank powers concerns the sta-

bility of the banking system.9  In a system without govern-

ment guarantees or distortions, private owners of any enter-

prise have the appropriate incentives to choose the capital

structure that permits the (privately) "optimal" amount of

stability.  The owners and managers of each enterprise de-

cide the degree of risk of loss they will tolerate for a

given expected level of return.

The optimal amount of stability in any industry, in-

cluding the financial system, does not imply zero failures.

Firms will enter and leave any healthy and dynamic competi-

tive sector.  Competition ensures efficiency through a win-

nowing process that eliminates firms that have poor manage-

ment or experience bad luck.

In the financial sector, however, stability is widely

perceived to be a distinct public concern because of a fear

that the owners of individual institutions will not take

into account the possibility that a failure of one institu-

tion might cause failures elsewhere.  Such linkages could

lead to a systemwide financial panic or "meltdown," which in

turn might cause a broader macroeconomic decline.  Bank own-

ers may not take this adverse externality into account in

pricing risk and determining the appropriate amount of pri-

vate capital to invest.  The socially optimal capital ratio

thus may be greater than the privately optimal one.  Since

the benefits of systemwide stability accrue to all economic

agents, not just banks, it may not be appropriate to have

only the bank shareholders bear its cost.

This potential negative externality provides the justi-

fication for government intervention to provide a "safety

net."  Banks are viewed as more fragile than other firms

mainly because of two features of a typical bank's financial

structure.  First, banks and financial institutions tend to

be highly leveraged; that is, they have a low capital-to-

assets ratio compared with nonfinancial firms.  Consequent-

ly, their cushion against insolvency is thinner than that of

nonfinancial firms.

Second, banks tend to hold a low ratio of liquid assets

relative to their highly liquid liabilities.  Because they