This commentary focuses on two specific issues. The first asks, What are the market failures that actually create the need for the public regulation of bank safety and soundness? The second issue concerns the safety and soundness issues created by the two mortgage government-sponsored enterprises, Fannie Mae and Freddie Mac, whose very large financial obligations pose a serious systemic risk threat to U.S. financial markets.Banks and banking ; Bank supervision ; Government-sponsored enterprises

Dwight M. Jaffee

English

Research Papers in Economics

114 ECONOMIC REVIEW First and Second Quarters 2007
A
s Mark Flannery notes, it is a luxury to be asked to prepare a paper to identify
major current questions regarding bank safety and soundness. It is an even
greater luxury to be asked to comment on Mark’s list of questions, particularly since
I agree with every topic on his list. In this commentary, I will focus on two specific
issues. The first, raised by Mark, asks, What are the market failures that actually create
the need for the public regulation of bank safety and soundness? The second, which
Mark omitted from his list but is at the very top of mine, concerns the safety and
soundness issues created by the two mortgage government-sponsored enterprises
(GSEs), Fannie Mae and Freddie Mac.
Safety and Soundness Supervision Derives from Some Market Failure
Mark opens his paper by asking why bank safety and soundness is a question of public
regulation in the first place, obviously a key question. Mark’s answer, with which I
agree completely, is that safety and soundness regulation must derive from some
market failure. But Mark does not drill down to a full answer. Since the answer will
determine whether we actually need bank regulation and, if so, what the best form is
for this regulation, I will try to provide a more complete answer.
A simple explanation of why we need bank regulation is, of course, to avoid fren-
zied bank runs. That answer may have been a sensible one in the 1930s, but today I
think we must consider whether capital market liquidity is now sufficient to extin-
guish irrational bank runs. After all, the breadth and depth of our capital markets is
one of the key strengths of the U.S. economy today. If capital markets can actually
provide bank liquidity, then we can save the money and effort currently invested in
this aspect of bank regulation.
Let me make the case for capital market liquidity. Suppose I manage the Jaffee
Bank of Berkeley, taking in deposits and making sound loans, but the maturity of my
loans exceeds the maturity of my deposits. Unfortunately, one day a bank run is ini-
tiated against the big banks in San Francisco, causing concern even among the
depositors at the Jaffee Bank. My solution would be simple and direct: I sell my port-
Two Key Issues Concerning 
the Supervision of Bank Safety 
and Soundness
DWIGHT M. JAFFEE
The author is the Willis Booth Professor of Banking, Finance, and Real Estate at the
Haas School of Business at the University of California, Berkeley. This commentary was
presented at the conference “Safe and Sound Banking: Past, Present, and Future,” held
August 17–18, 2006, and cosponsored by the Federal Reserve Banks of San Francisco
and Atlanta and the founding editors of the Journal of Financial Services Research.
COMMENTARY
JAFFEE commentary  4/12/07  4:13 PM  Page 114FEDERAL RESERVE BANK OF ATLANTA 
ECONOMIC REVIEW First and Second Quarters 2007 115
folio of loans in the capital markets, using the proceeds to pay off my depositors. I am
not happy about the event because I lose the profit spread I was earning, but the sit-
uation is not disastous. In fact, my reputation for paying off my deposits is enhanced,
and when the bank run panic subsides, I can regain my deposits and repurchase my
loans. As long as I can depend on capital market liquidity as an outlet to sell my loans,
I have no need for government liquidity and for the bank regulation that it creates.
The problem with this story, of course, is that the U.S. capital markets do not
seem able, at least on a consistent basis, to provide this type of liquidity. Instead, we
observe capital market liquidity crises in which market investors are suddenly unwill-
ing to invest at all—or investors quote risk spreads that amount to the same thing—
even though on the previous day identical securities were bought and sold in liquid
and deep markets. Even more interestingly, the trigger events that create such cap-
ital market crises often seem very remote from the security markets that face the
crises. I am thinking of the recent crises that started with Russian government bonds
or Asian currencies but ended up dramatically raising the risk spreads for such secu-
rities as U.S. residential and commercial mortgage-backed securities. Since no obvi-
ous link exists between Russian bonds and U.S. mortgages, why the liquidity crisis
spread in this way is an intriguing question. One answer, just now being developed in
research papers, is that investors foresaw a possible chain of broken financial con-
tracts and thus became extremely conservative in their willingness to invest until the
crisis abated (see Caballero and Krishnamurthy 2006).
I suggest that this tendency of capital markets to expand panic to sectors with
no direct links to the initial crisis underlies the need for public regulation of bank
safety and soundness. After all, if the capital markets cannot dependably provide liquid-
ity, then frenzied bank runs will occur, and a lender of last resort at the Federal Reserve
and a deposit insurance fund can make sense. 
Moreover, I suggest that this market failure also has implications for other financial
services. As an example, Thomas Russell and I have a series of papers about how the fail-
ure of private markets for catastrophe insurance has led to inefficient government inter-
ventions in these markets (Jaffee and Russell 2006). The examples include the creation
of federal flood insurance starting in the 1960s, the breakdown of Florida wind-damage
insurance due to Hurricane Andrew in 1992, the failure of California earthquake insur-
ance due to the 1994 Northridge quake, and, most recently, the breakdown of terrorism
insurance due to the 9/11/2001 attack. It is understandable, of course, that the price of
these catastrophe lines could rise after an event, especially if insurance firms raise their
estimates of expected future losses. It is not easily explained, however, why large parts
of the private insurance industry simply refuse to offer policies the day after the event
even though they were doing so quite happily the day before. Russell and I believe the
explanation is a capital market failure, in which catastrophe insurers find that their
capital market access has dried up as a result of the event even though their business
is expected to be very profitable as market premiums rise.
The connection here is that we see government interventions in a wide range of
financial services—from bank deposits to catastrophe insurance. In all these cases, we
must understand the underlying market failure in order to evaluate whether and how
that intervention should occur. I believe it is of fundamental importance to provide a
full answer to this question. 
A New Item for Bank Supervision: Fannie Mae and Freddie Mac
The second issue I will discuss concerns the two mortgage GSEs, Fannie Mae and
Freddie Mac. Mark Flannery does not include the two GSEs on his topic list, but I
JAFFEE commentary  4/12/07  4:13 PM  Page 115116 E C O N O M I C   R E V I E W   First and Second Quarters 2007
consider them a major factor threatening
commercial  bank  safety  and  soundness
today. The source of the problem is that
Fannie and Freddie currently embed very
large amounts of interest rate risk in their
retained mortgage portfolios (Jaffee 2003).
One might think that Fannie’s and Freddie’s
financial distress is a problem only for
investors holding their obligations or for
their  regulator,  the  Office  of  Federal
Housing Enterprise Oversight (OFHEO),
and not for the commercial banking indus-
try. The financial obligations of the two
firms, however, are now so large that they
create a very serious systemic risk that
could envelop all the U.S. financial mar-
kets, including the commercial banks. The
table provides some summary statistics
showing that Fannie and Freddie are larger
than whole sectors of the U.S. capital market, with their capital market obligations
exceeding the total amounts for all corporate bonds, commercial loans, municipal
bonds, and nonmortgage consumer loans outstanding in the U.S. capital market.
Specifically, with respect to U.S. banks, consider these facts as of year-end 2005: 
• Fannie’s and Freddie’s total obligations equaled $4.2 trillion, representing 55 per-
cent of total U.S. bank liabilities. ( (At year-end 1985, in contrast, the two GSEs’
obligations represented 8 percent of total U.S. bank liabilities.) 
• Fannie and Freddie were larger than any U.S. banks based on total obligations.
• Fannie and Freddie would both be among the top six U.S. banks based on assets. 
• Investments in Fannie’s and Freddie’s obligations exceed 14 percent of all U.S.
commercial bank assets.
Congress has been considering bills for reorganizing the regulation of Fannie and
Freddie, indicating further concern with their safety and soundness (Glaeser and Jaffee
2006). One response, especially by Freddie Mac, has been to argue that the regulation
of the two GSEs for safety and soundness is already on par with that of commercial
banks (see, for example, Syron 2005). I think it is important for bank regulators to hear
this argument and to rebut it. Here are some of my notes for this rebuttal:
1. The  U.S.  Treasury  does  not  backstop  the  Federal  Deposit  Insurance
Corporation (FDIC). Fannie  and Freddie have a direct credit line at the U.S.
Treasury, and capital market investors generally assume that an implicit U.S. Treas-
ury guarantee exists on all of Fannie’s and Freddie’s obligations. In contrast, the
FDIC provides only a mutual guarantee among all the banks, with no links what-
soever to the U.S. Treasury.
2. Bank capital requirements far exceed those of Fannie and Freddie. The
effective capital requirement for the two GSEs is just over 1 percent, reflecting
a weighted average of 2.5 percent for their balance sheet assets and 0.45 percent
for their mortgage-backed security guarantees. Most banks, of course, carry cap-
ital ratios in excess of 8 percent. In addition, banks hold diversified portfolios
FEDERAL RESERVE BANK OF ATLANTA 
Table
U.S. Capital Market Obligations by Sector
Year-end 2005
($ trillions)
U.S. commercial bank liabilities $7.7
7 . 4 $ t b e d   y r u s a e r T   . S . U
Total obligations, Fannie and Freddie $4.2
4 . 2 $ s n o i t a g i l b o   e a M   e i n n a F
8 . 1 $ s n o i t a g i l b o   c a M   e i d d e r F
0 . 3 $ s d n o b   e t a r o p r o c   l l A
4 . 2 $ s n a o l   l a i c r e m m o c   l l A
2 . 2 $ s d n o b   l a p i c i n u m   l l A
All (nonmortgage) consumer credit  $2.2
Note: Fannie Mae and Freddie Mac obligations equal total debt plus
net mortgage-backed securities outstanding.
Sources: Federal Reserve Flow of Funds, Table L.2; for Fannie Mae,
Debt Activity, December 31, 2005, and Monthly Summary, April 2006;
for Freddie Mac, Caballero and Krishnamurthy (2006)
JAFFEE commentary  4/12/07  4:13 PM  Page 116while Fannie and Freddie mainly hold a single asset class—namely fixed-rate,
long-term, freely prepayable mortgages.
3. Bank regulation includes prompt corrective action (PCA). As discussion
at this conference confirmed, PCA has greatly expanded the safety and sound-
ness of U.S. banking by creating a mechanism through which distressed banks
must either add to their capital or merge. The regulation of Fannie and Freddie
has no comparable power, leading to a serious concern that financial distress at
either firm would lead first to forbearance and, later, to a federal bailout.
4. Risk diversification. Financial distress for Fannie and Freddie would focus on
just two firms, with the likelihood that any serious issue at one firm would migrate
quickly to the other. With over 7,000 U.S. commercial banks, the risk would be
dispersed over many more firms.
In closing, I will return to Mark Flannery’s list to highlight an important issue of high
relevance for both Fannie and Freddie and for bank regulation: the Basel II propos-
als for capital adequacy. The current proposals will reduce the capital requirements
imposed on residential mortgages, whether held as whole loans or as mortgage-
backed securities. This reduction will expand the incentive for banks to hold these
loans and securities, which is a good thing if it creates a reduction in the retained
mortgage portfolios held by Fannie and Freddie. On the other hand, we should not
forget that Basel II has no direct capital requirements for interest rate risk. For me,
the highest priority is to create a capital requirement system in which interest rate
risk is treated as a fundamental risk factor, with its own quantitative capital require-
ments, quite on par with those for credit risk.
117 ECONOMIC REVIEW First and Second Quarters 2007
FEDERAL RESERVE BANK OF ATLANTA 
Caballero, Ricardo J., and Arvind Krishnamurthy. 2006.
Flight to quality and collective risk management. NBER
Working Paper No. 12136, April.
Glaeser, Edward L., and Dwight M. Jaffee. 2006. What to
do about Fannie and Freddie? The Economists’ Voice 3,
no. 7. <www.bepress.com/ev/vol3/iss7/art5>.
Jaffee, Dwight. 2003. The interest rate risk of Fannie
Mae and Freddie Mac. Journal of Financial Services
Research 24, no. 1:5–29.
Jaffee, Dwight, and Thomas Russell. 2006. Should
governments provide catastrophe insurance? The
Economists’ Voice 3, no. 5. <www.bepress.com/ev/
vol3/iss5/art6>.
Syron, Richard F. 2005. Prepared Remarks for Richard
F. Syron, Chairman and CEO, Freddie Mac, to The
Executives’ Club of Chicago, December 6. Available at
http://freddiemac.com/speeches/syron/ds120605.html.
REFERENCES
JAFFEE commentary  4/12/07  4:13 PM  Page 117

Two key issues concerning the supervision of bank safety and soundness

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Two key issues concerning the supervision of bank safety and soundness

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