Tuesday, August 4, 2009

the federal financial safety net

the Fed views its role as custodian of the financial system and lender of last resort to be the first two layers of the federal financial safety net, which is a term for the various federal government protections against widespread financial failures and panics. from this perspective, the fed‘s function as financial system custodian permits it to maintain a day-to-day involvement in the nation‘s payments system, both through its own payments system operations (check clearing and Fedwire) and through its supervisory role. As a result of its custodial role, the Fed is able to observe problems as they initially arise and, at least in principle, can respond to those problems with appropriate adjustments in its services and supervision. This, then, is the first layer of a federal " safety net" of protection for the financial system.
the second layer is the Fed‘s role as lender of last resort, If,by chance, the Fed‘s custodial operation are insufficient to prevent events that might precipitate instances of illiquidity and systemic breakdown, the fed is there to provide liquidity, through discount window loans, to solvent but temporarily illiquid depository institutions.
the Fed has no direct responsibility for the third, and final, layer of the federal financial safety net. this last layer is the federal deposit insurance system. In cases in which institution‘s illiquidity is permanent, rather than temporary, because they have become insolvent, deposit insurance is available to protect the 'small" depositors.

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