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).

Financial sector guarantees are a key public policy tool

All financial claims are risky. Against this background, governments have traditionally provided support for guarantees of financial claims, provided they of public policy interest. This  choice is based on the view that adequately priced financial transactions enhance welfare. Ideally, such transactions allow risk to be allocated to those most capable of bearing it. By conveying reassurance, guarantees encourage risk-taking and activity that otherwise wouldn’t occur.

Governments provide guarantees in various ways. They directly provide guarantees for claims among private entities. They also encourage private financial intermediaries to provide guarantees. And they also make available subsidies, favorable regulatory treatment or public back-stops. There are many examples of financial sector guarantees, including retail deposit insurance, pension benefit guarantees, and guarantees for bank loans to small and medium-sized businesses.

Costs and benefits need to be better understood

International organisations intensify their work on financial sector guarantees since the 2008 global financial crisis. Most policy responses for achieving and maintaining financial stability consisted of providing new or extended guarantees for the liabilities and assets of financial institutions. But even before this, guarantees were already an instrument of first choice to address a number of financial policy objectives. Such objectives are various. They include protecting consumers and investors and achieving more desirable credit allocations.

Alternatives to guarantees exist. For example, to achieve more desirable credit allocations, public entities also lend directly. In Europe, for example, direct public lending in less well developed financial market segments has been shown to achieve additional growth of beneficiary firms as compared to similar peers. Nonetheless, the incidence and scope of various types of financial sector guarantees is increasing steadily.  To explain, this type of public intervention is easier to justify given tight fiscal constraints and it conceptually leaves room for private initiatives.

Guarantees are a preferred policy instrument. Thus, a number of OECD reports analyse financial sector guarantees in light of ongoing market developments and discussions within the OECD Committee on Financial Markets. They show how the perception of the costs and benefits of financial sector guarantees  evolve in reaction to economic and financial market developments. This includes in particular the outlook for financial stability and real activity. Regardless of the specific context, a key conclusion is that financial sector guarantees need to be adequately priced. This way they can achieve their desired effects in terms of financial stability and economic efficiency. By contrast, underpriced guarantees create distortions to incentives.

Some guarantees remain underpriced

Unfortunately, some guarantees are not adequately priced. For example, access to the financial safety net is not adequately priced, giving rise to implicit guarantees. These are by definition not charged for, at least not explicitly. They are costly and distort capital allocation. This situation is evident from long-term growth trends. “Financial excesses” – situations where bank credit reaches levels that reduce real economic growth – have been stronger in  OECD countries characterised by larger values of implicit bank debt. As a result, the banking sector has grown to levels not conducive to real activity growth. Implicit bank debt guarantees benefit financial sector employees and other high-income earners, increasing income inequality. Thus, policy makers attempt to rein in the values of such guarantees not only to make the financial system more efficient and stable but also fairer.

An evaluation by the Financial Stability Board of the effects of too-big-to-fail (TBTF) reforms identifies progress in this regard and remaining gaps. The estimated value of implicit guarantees has declined from its peak. It is however higher than before the 2008 crisis. The evaluation concludes that more can be done to fully realise the benefits of these reforms.

Will fintech make banks less “special”?

The short answer is no. Banks manage two sets of cash flows – deposits and loans – and provide two key services – liquidity provision and maturity transformation. Banks provide these services in bundled form. As a result of their activities, they are subject to potential “runs”. Thus, banks face comprehensive oversight. This regulatory and supervisory constraint  is part of banks’ access to the publicly supported financial safety, which includes financial sector guarantees such as deposit insurance. It is this access that makes banks “special”.

Unbundling of financial services

Fintech implies an unbundling of the provision of the financial services provided in bundled form by banks, making the delivery of each individual service more convenient and cheaper. Traditional banks respond by buying up or collaborating with fintech entities to enhance their own efficiency. Nonetheless, they will continue to face competitive threats as regards specific types of services. As a result, bank profits in these specific areas will continue to face pressures.

Fintech’s effect is most acute in lending, payments, and customer experience. Examples include the following. Peer-to-peer (P2P) and balance sheet lending models directly compete with banks in lending. Digital wallets and instant payment platforms bypass traditional payment rails. They reduce banks’ fee income from card processing and wire transfers. Fintech provides highly personalised, convenient and often cheaper financial services. It democatrises access to processes that were once exclusive to banks.

The longer answer

Nonetheless, central banks continue to rely on the bank lending channel for their own steering of financing conditions for firms and households. In the current fractional reserve banking system, banks can lend out a significant portion of the deposits they receive, thereby expanding the overall money supply. Central banks currently rely mainly on banks to transmit monetary policy impulses. That said, to the extent that central banks issue their own central bank digital currencies (CBDC) directly to retail customers, things will change fundamentally. As a result, the role of banks will evolve as well as the extent of privilege that banks benefit from. Thus, the longer answer to the above question is more nuanced.

Research by economists, formerly OECD, (here and here) suggests that banks have long been regarded as “special”. Private banks occupy a key role in the current financial and monetary system. In exchange, they are given access to the publicly supported financial safety net. This privileged role is not set in stone, however. In fact, an element of circularity exists. This issue is illustrated in the chart below. On the one hand, identifying banks as “special” qualifies them for access to the financial safety net. On the other, for banks to effectively perform some of their core characteristic economic functions — liquidity provision combined with maturity transformation — requires them to have access to the provisions financial safety net. That access, in turn, makes them “special”. Other entities aim to and might succeed in obtaining similar access. 

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.