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.

Do public venture loans help overcome the diagnosed financing gap for SMEs in Europe and help them to grow?

The preferred policy tool to achieve more desirable credit allocations consists of financial sector guarantees,  e.g. for bank lending or securitisations of claims. Alternatives exist, however. A recent example is direct public venture lending to SMEs and somewhat larger firms. Venture debt consists of long-term loans with repayment obligations linked to company performance. It complements venture capital and funds scale-up of enterprises. The European market for venture debt is not yet well developed and considerably smaller than the US market, but growing. The growth reflects the activity of the European Investment Bank (EIB), a public bank.

A 2022 study of EIB venture debt activities since 2015 shows that beneficiaries, relative to comparable peers that do not receive such loans, report significantly larger asset growth and productivity. They also report higher additional debt, which suggests crowding-in of other financiers by signaling that the beneficiary is promising and soundly managed. The graph shows the cumulative effect on total assets relative to the year prior to loan signature and to peers. Venture debt beneficiaries report about 30% more assets, on average over the three subsequent years.

The signaling effects of public intervention are likely particularly relevant in less-developed financial market segments, such as the European venture debt market. To what extent results translate to more developed financial market segments, and public support for SMEs more generally, is not clear. Rigorous impact assessment of the various long-standing financial support programmes is still not standard practise internationally.