Financial Consolidation: Dangers and Opportunities

This paper argues that although financial consolidation creates some dangers because it is leading to larger institutions who might expose the U.S. financial system to increased systemic risk, these dangers can be handled by vigilant supervision and a government safety net with an appropriate amount of constructive ambiguity. Financial consolidation also opens up opportunities to dramatically reduce the scope of deposit insurance and limit it to narrow bank accounts, thus substantially reducing the moral hazard created by the government safety net. Reducing the scope of deposit insurance, however, does not eliminate the need for a government safety net, and thus there is still a strong need for adequate prudential supervision of the financial system. Moving to a world in which we have larger, nationwide, diversified financial institutions and in which deposit insurance plays a very limited role, should improve the efficiency of the financial system. However, it is no panacea: the job of financial regulators and supervisors will continue to be highly challenging in the future.