Systemic risk and consumer protection are the main rationales for the introduction of safety net arrangements in the form of deposit insurance and lender of last resort. Deposit insurance prevents the occurrence of panic runs while maintaining banks’ ability to provide liquidity insurance (Diamond and Dybvig, 1983).
The issue of the optimal form of central bank intervention has long been debated. According to the "classic" view (Bagehot, 1873), central banks should lend freely at a penalty rate and against good collateral. This should guarantee that the lender of last resort (LOLR) is only used for illiquid banks and in emergency circumstances. In practice, however, it is difficult, even for central banks, to distinguish illiquidity from insolvency. Banks in need of LOLR are under a suspicion of insolvency since they could otherwise raise funds from the market. As long as markets are sufficient to deal with systemic liquidity crises, there should be no need for central bank's loans to individual banks. However, the interbank market may fail, as it has happened in the recent subprime crisis and then help to individual banks makes sense (as explained in Rochet and Vives, 2004).
A related aspect in this debate concerns the potential negative effects of the safety net arrangements. The main argument is that they worsen the problem of excessive risk taking and call for further regulatory measures in the form, for example, of minimum capital requirements. Moreover, the form of central bank intervention is important for competition policy. Direct subsidies or bailouts of financial institutions fall into the category of state aid and have a direct impact on the application of competition policy to the banking sector.
3. Competition in the banking sector Analyzing competition in the banking sector is quite complicated. On the one hand, the standard competitive paradigm does not work because of features like asymmetric information in corporate relationships, switching costs and networks in retail banking. On the other hand, some banks’ specificities, like the fact that they compete for loans and