Significant attention has recently been directed to the optimal policy response
when financial excesses threaten. This paper rather addresses issues pertinent
to the appropriate policy response once financial difficulties have actually
materialised. It begins with some empirical evidence concerning recent changes
in financial structure (marketisation, globalisation and consolidation) and
documents the rise in the number and variety of episodes of financial
instability. The paper then goes on to examine the rationale for government
intervention (use of safety net instruments) to reduce the costs of such
financial instability, and cautiously concludes that the use of a number of such
instruments has been on the rise. Moreover, the balance among them has also been
changing. An attempt is then made to link these evolving policy responses back
to the underlying changes in financial structure identified earlier.
Since the use of safety net instruments always implies in
principle some element of moral hazard, the paper concludes with an empirical
evaluation of whether this seems to be a matter of practical importance, and
whether "good design" might not have the potential to materially reduce such
concerns. The conclusion reached is that sensible policies designed to contain
the damage arising from financial instability can have less desirable
longer-term consequences. Policymakers thus continue to face an inter-temporal
optimisation problem.