Roles and Contributions of Federal Credit and Insurance Programs

Abstract

This paper evaluates the contributions of federal credit and insurance programs based on their effectiveness in addressing imperfections in credit and insurance markets, including adverse selection caused by asymmetric information, moral hazard resulting from monitoring difficulties, resource constraints caused by high transactions costs, limited ability to absorb hard-to-predict exogenous shocks, and temporary disequilibria caused by overreactions of market participants. For the purpose of subsidizing target populations, other policy tools, such as direct subsidies and tax credits, can be more effective. During normal times when economic agents behave rationally, credit programs including Government Sponsored Enterprises (GSEs) make at best minor contributions. Subsidized federal loans have ambiguous effects on adverse selection. The private market is capable of providing sufficient liquidity without GSEs. In a financial crisis when lenders may be overreacting to increased loan delinquencies, federal credit programs can be a critical source of funding. However, this secondary role alone may not be enough to justify continuous presence of credit programs. Insurance programs have stronger justifications. Regulatory authority gives the federal government an advantage in monitoring certain types of policyholders, such as depository institutions and pension funds. The most critical advantage of the federal government derives from its ability to secure enough resources ex post to honor claims. Thanks to this ability, the federal government can provide credible insurance against hard-to-predict catastrophic events.