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1920s and 1930s, commercial banks in the United States that

actively engaged in the securities markets were less likely

to fail than were other commercial banks.17  In addition,

banks with securities operations tended to have higher capi-

tal ratios and lower variance of their cash flows than did

other banks.  Involvement in the securities business, thus,

appears to have helped banks to diversify and thereby en-

hanced their stability during the 1920s and 1930s.

Safety Nets and Market Discipline

Given that the concerns about the inherent fragility of

banks and the banking system may be overstated, the next

step is to evaluate the role of the regulatory safety net

that governments--implicitly or explicitly--have placed un-

der their banking systems.  While, in principle, safety net

measures could increase the stability of the system, in

practice, it has proven difficult to design a safety net

that does not undermine both efficiency and stability.

Improperly designed safety nets may encourage behavior by

both the insured banks and their regulators that over time

is likely to prove far costlier than the benefits safety

nets may generate.  As has been clearly demonstrated in

almost all countries in recent years, poorly designed and

implemented deposit insurance, for example, has greatly

reduced depositor discipline of banks and thereby encouraged

them to engage in moral hazard behavior, by assuming greater

credit and interest rate risk exposure in their asset and

liability portfolios and by maintaining lower capital ra-

tios.

By short-circuiting market discipline, deposit insur-

ance also allows bank regulators to engage in regulatory

forbearance, delaying the imposition of sanctions on trou-

bled banks and permitting even economically insolvent insti-

tutions to continue to operate.  The costs of forbearance

can be and have been very large.18

Without government guarantees of deposits, insolvent

banks could not stay in business long.  Banks receiving low

ratings from depositors as well as independent private rat-

ing agencies would either have to compensate depositors with

higher interest rates or see funds flow out.  Withdrawals by

informed depositors might force troubled banks to sell as-

sets quickly and perhaps experience fire-sale losses.  If a

bank could no longer satisfy the depositors' demands in full

and on time, it would close (suspend operations) either vol-

untarily or at the order of the regulators.  In addition,

without the strong "heads I win, tails you lose" character