The IMF on Bank Subsidies

If a bank is too important to fail (TITF), it in effect gets a subsidy from the public. That subsidy is like an insurance contract for those who lend to these banks: if the bank looks like it will fail, it will be bailed out by the government and depositors will get their money back. This in turn means that TITF banks can borrow more cheaply, so they get the benefit of this subsidy every year. TITF banks could do various things with this subsidy: they could make their loans to firms or consumers cheaper (thereby undercutting competition from smaller banks), they could make higher profits that go to either shareholders or as bonuses to bankers themselves, or they could take excessive risks. They will probably do some combination of all of them.

In 2009 the Bank of England calculated the value of this subsidy at £109 billion: that is about £1750 for each person in the UK. The TITF banks of course dispute this figure. (Donald MacKenzie has a very readable account of one example in the London Review of Books.) A week ago the IMF published their own study (pdf), using two different market based methods to measure this subsidy. (The IMF chapter is very readable, but Simon Johnson also has a good summary here.) This is a very imprecise science, but the IMF confirm that subsidies to TIMF banks are very large, although the £109 billion figure quoted above is probably at the upper end of the range of estimates (as the Bank also acknowledged in a later study). However, if we described this number as each member of the public’s contribution to help pay bankers bonuses (which it could well be), I think everyone would agree even a more modest figure is unacceptable.

There are two particularly interesting features of the IMF analysis: it calculates numbers across countries and across time. On the first, some might have assumed that TITF subsidies would be largest in the US, but this is not the case. In dollar terms subsidies in the UK and Japan are of a similar size to the US, and of course the UK is a smaller country, so per capita subsidies are larger in the UK. In dollar terms subsidies appear largest in the Euro area. The IMF also calculate subsidies before the crisis (2006-7), during the crisis (2008-10) and after the crisis (2011-12). The worrying aspect of these calculations is that the subsidies do not seem to have fallen substantially in the post crisis period compared to pre-crisis.

Worrying, but hardly surprising. In principle the TITF problem is fairly easy to solve: as Admati and Hellwig convincingly argue the proportion of the bank’s balance sheet that is backed by equity should be much much higher. (In simple terms, if a bank gets into trouble there are many more shareholders able to absorb losses before a government bailout is required.) The problem of TITF banks is political. As I discussed here, the lobbying power of the TITF banks is enormous. This is not just a matter of bribing campaign contributions to politicians. In the UK there is some evidence that the depth of the recession is partly down to lack of lending by banks, and the bank’s response to any proposals to tighten regulation is to imply that this will ‘force’ them to lend even less. If it is suggested that additional capital could come from reducing bank bonuses, they say all the talent will migrate to overseas banks. Quite simply, the TITF banks have immense power. Until the political will to take on the banks is found, we will each continue to subsidise bank bonuses.

And there will be further financial crises. For those in the UK who think the Vickers Commission put this problem to bed [1], it is essential to read this article by one of its members, Martin Wolf. In reviewing the Admati and Hellwig book, he writes: “Once you have [understood the economics], you will also appreciate that we have failed to remove the causes of the crisis. Further such crises will come.”

Postscript: for more, see this discussion via Mark Thoma.

[1] Because the IMF study tracks estimates of the subsidy to TITF banks through time, it can look at how the subsidy changed when the Vickers report was published (Table 3.2 and Figure 3.8). Publication is associated with a significant fall in the subsidy, but it was not nearly enough to eliminate it.   

Banks, economists and politicians: just follow the money

Economics rightly comes in for a lot of stick for failing to appreciate the possibility of a financial crash before 2007/8. However it is important to ask whether things would have been very different if it had. What has happened to financial regulation after the crash is a clear indication that it would have made very little difference.

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis? I think they would have been ignored then even more than they are being ignored now. The single most effective way of avoiding another financial crisis is to reduce the political influence of the banking sector.      

[1] The optimum amount of equity is not 100%, in part because some (subsidised) borrowing does increase discipline on bankers. For a good discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative to the state picking up the bill is to inflict losses on depositors, but the economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has got itself into with this following the Cyprus crash: see also Simon Johnson here.

[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch operation in modern history, where a banking crisis involving private sector debts was turned into a public sector debt crisis. While I would be the last person to defend the macroeconomics status quo, I also think there is an element of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory tells us a lot of useful things about how to get out of the recession, if only politicians would take some notice.