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of the safety net, the bank owners might have chosen a dif-
ferent initial risk profile for the bank. As noted above,
prior to the introduction of the lender of last resort in
the United States, bank failure and loss rates were lower
than those for nonfinancial firms.
The problems of moral hazard are not associated only
with the existence of a government safety net; they also
exist in many market contexts, so it is valuable to under-
stand how the market deals with such problems. Private
markets address those problems through debt covenants that
tend to prevent, rather than provide forbearance for, exces-
sive risk taking.19 Debt covenants are explicit provisions
in debt contracts that restrict a firm's behavior and abili-
ty to take risks. Banks often include such provisions in
their own loan agreements with firms. Covenants are trig-
gered as soon as earnings or capital fall below prespecified
levels or leverage rises above such levels. In some cases,
covenants allow the debt holders to seize control of the
firm as the firm experiences financial distress. Covenants
thus prevent a distressed firm from continuing to operate as
it did before and attempt to prevent it from increasing its
risk exposure.
When government deposit insurance is implicit or ex-
plicit, regulatory discipline should be structured to mimic
the way in which the market deals with the moral hazard
problem.20 Rather than permit regulatory forbearance, the
government should require that regulators follow clearly de-
fined practices to restrict the risk-taking activities of
banks experiencing financial distress and to resolve their
problems before they become deeply insolvent. In parallel
with private debt covenants, intervention by regulators
could be related to capital ratios or other performance and
solvency measures. Such regulatory discipline would prevent
depositor (and taxpayer) losses at individual institutions
from growing and possibly causing systemwide problems. The
Federal Deposit Insurance Corporation Improvement Act of
1991 was a first step toward introducing explicit interven-
tion and closure rules in the United States.21
Geographic Rationalization and Consolidation
of Banking through Mergers
Having discussed what type of internal bank structures
market forces are likely to give rise to, I focus now on the
likely structure of the banking industry itself as mergers
and consolidations continue.22 A two-tiered banking system
in which nationwide and regionwide banks coexist with small-