Banking sector extraordinary privileges

Banks benefit from an extraordinary privilege: in times of impending systemic financial crises, governments act as guarantors of last resort for banks’ financial obligations. This privilege is not paid, at least not directly.

Banks are subject to taxes, like other corporations. In addition, some countries such as the Czech Republic, Hungary, Italy, Lithuania, and Spain have recently imposed extraordinary levies on banks. The justifications provided by the governments for these levies and the ECB’s critics  avoided to refer to these taxes as a charge for the above-mentioned extraordinary privilege of banks. Instead, they seem to be primarily motivated by fiscal needs.

Government guarantees are necessary

Governments worldwide provided explicit or implicit guarantees to financial institutions and creditors in response to the 2007 global financial crisis. This governmental role in offering a safety net to the financial sector is essential to prevent the systemic collapse of the economy for two reasons:

First, to prevent systemic collapse. Financial institutions are closely linked, and their failure can cause a cascading effect leading to a severe economic crisis. Governments guarantee financial institutions and creditors to restore confidence and avert a financial system collapse.

Second, to sustain essential institutions. Some financial institutions are “too big to fail” or have significant importance for other reasons, and their failure could cause severe economic damage. Banks are important for lending, deposits, and payments.

To safeguard the broader economy and to protect households considered particularly vulnerable, governments have become the guarantor of last resort for private financial claims involving these institutions.

The moral hazard dilemma

This role gives rise to implicit guarantees which have economic value but are not priced. Such guarantees in turn induce moral hazard, where banks take excessive risks, expecting government rescue if they fail. The 2023 SVB and Credit Suisse cases show that this risk is real despite a decade of regulatory reforms. Economists  propose several additional solutions to address this risk, including the following.

Charging Fees

Some economists suggest governments impose fees for financial guarantees, considering risk and potential fiscal costs. This approach encourages institutions to exercise caution as they essentially pay for the safety net. This concept can be likened to charging admission to a poker game and credibly announcing that any losses incurred remain private. Players can be expected to become more prudent, knowing that there is a cost involved.

Strengthening fiduciary rights of taxpayers

Another proposed solution is to ensure that those who bear the financial burden of bailouts have a voice in determining the fate of financial institutions that take excessive risks. Kane (2014) argued that taxpayers, de facto, are coerced equity investors with unlimited liability, which is why corporate law should be modified to accord taxpayers with the same fiduciary rights to prudent stewardship that the law already gives to explicit shareholders.

Transparency and accountability

Transparency can hold financial institutions accountable by revealing guarantee terms and beneficiaries and monitoring their effects. Reporting this information to the public and parliament can increase oversight, ensuring that government guarantees are used responsibly. An example is budgetary practice, which explicitly reports the potential contingent liabilities arising from the banking sector, as in Australia. Public debt managers also make these estimates.

Tweak the mix of policy responses?

Governments hesitate to assign price tags and to enhance transparency about contingencies. A decade ago, the OECD surveyed policymakers on the best way to limit implicit guarantees of bank debt. The survey found that a mix of policy measures was considered helpful. Common policy measures include capital/liquidity standards, tighter supervision, and improved bank failure resolutions. The least popular option was to “produce estimates of the value of implicit guarantee and charge for it” (Figure 1). While putting a price on implicit guarantees to discourage their “use” is conceptually attractive, as is enhancing transparency, policymakers fear such measures further entrench ‘bail-out’ expectations.

Recently imposed extraordinary bank levies do not seem to be an attempt to charge a “user fee” for the extraordinary privilege that banks receive as a group. Instead, fiscal pressures seem more relevant. Design and implementation of an economic “user fee” would require closer collaboration between the various institutions that provide the financial safety net, that is regulators, treasuries, central banks, and deposit insurers. Both within and across national borders.

Figure 1: Categories of policies to limit the value of implicit bank debt guarantees

Source: Responses from 35 countries to OECD survey (Figure 2, p. 15).

Are changes in regulation and resolution regimes sufficient to reduce the value of implicit bank debt guarantees? Or are actual losses for bank creditors needed?

Banks continue to benefit from implicit guarantees (Schich, 2018). Market participants’ expectations that public authorities might bail out the creditors of banks considered too big or important for another reason to be allowed to fail, give rise to such guarantee. Such perceptions imply that banks’ access to the financial safety net guarantees is not adequately priced, as these guarantees are not charged for. These perceptions are economically costly (e.g. Denk et al., 2015).

Thus, public authorities have set out to limit them. As aptly summarized by Schäfer et. al. (2016), however, actions speak louder than words in this regard. Mere regulatory and resolution regime changes are not very effective. By contrast, bailing in creditors of insolvent banks is effective in reducing such perceptions (Kim and Schich, 2012).

The costs of protection of subordinated debt, as compared to senior debt, are higher. They have also increased over time. Junior, as opposed to senior, creditors of banks are perceived as more at risk of being bailed in than they were previously. The difference in bail-in perceptions between the two classes of debt have become more pronounced. This is shown by the red arrow in the chart below.

A study with colleagues from the European Commission Joint Research Centre in Ispra confirms that progress has been made following the 2011/12 European financial market turmoil. The value of implicit bank debt guarantees for some types of debt has declined noticeably. However, the study also suggests that when the bail-in of creditors of a struggling bank does not occur (a sort of “no action”), the value of implicit guarantees for senior debt increases. Actions, or the lack of them, speak louder than words. As a result, the perception that senior as compared to junior bank debt is particularly protected became further entrenched.