The views expressed within this post are those of the author alone and do not represent those of the OECD or its member countries.
A decade after the global financial crisis, most of the financial regulatory reform package to make the system stabler and fairer has been completed. The agenda is is now changing to evaluation of reform effects. This post draws on a recent article on implicit bank debt guarantees [1] and asks whether the progress in limiting them has made the financial system fairer.
The financial regulatory reform, designed and subsequently rolled out over the past decade following the global financial crisis, is explicitly described as an attempt to make the international financial system fairer. In defining what is involved in this goal, the Financial Stability Board (FSB),[2] an international body set up in April 2009 to monitor and make recommendations about the global financial system, refers to large banks at the centre of the financial system that did not internalize the social costs that their excessive risk-taking created. Gains of risk-taking activities were privatized and losses socialized. A fairer system involves funding conditions that are more closely aligned with the riskiness of the entities. In other words, there would be no room for implicit bank debt guarantees.
The expectation by market participants that public authorities might bailout the creditors of a bank, if in distress, is commonly referred to as an “implicit debt guarantee.” The guarantee is not explicit, and public authorities might honestly state that they do not want to bail out the bank ex ante. They may, however, feel compelled to do so ex post, especially if they consider a bank “too big to fail” or too important for another reason to be allowed to exit the market. Such situations can arise in particular if the bank is considered crucial for the system, that is, the banks’ failure might be a threat to the financial system, with severe adverse consequences for real economic activity. Implicit bank debt guarantees create distortions to competition and risk-taking incentives, encouraging bank managers and owners to take excessive risks so as to maximise the value of the implicit guarantee. As a result, banks increase their leverage and too many funds are channelled to the banking sector, as opposed to other sector of the economy.
The possibility of exit of banks from the market needs to be credible. The financial crisis had highlighted that large and complex banks could not be resolved in a manner that maintains the continuity of critical functions, while shielding taxpayers from the risk of loss. In the meantime, much progress has been made. Larger and better-quality capital and liquidity buffers have been established at large banks and the interconnections within the core financial system have been reduced. Moreover, to facilitate smooth exit of non-viable banks, FSB members developed a set of policy measures for systemically important financial institutions, including in particular an international standard for resolution, the so-called key attributes of effective resolution for financial institutions. Most home and key host jurisdictions of global systemically important banks have introduced resolution regimes that are broadly aligned with this standard.
Admittedly, for large international banks on aggregate, the value of implicit guarantees has declined from their peaks attained a few years ago. That said, a recent survey of the empirical literature of implicit bank debt guarantees (see reference above) suggests that the value, expressed for example in basis points of interest rates funding cost advantages, remains quite substantial.
Moreover, empirical work on the economic determinants of the value of implicit bank debt guarantees suggests that some undesirable links continue to prevail. Results confirm that financially weaker banks benefit from higher values of implicit debt guarantees, just like any type of insurance becomes more valuable the weaker the benficiary is. Results also suggest that the value of implicit bank debt guarantees not only reflect bank weakness but also the strength of the sovereign, with banks located in countries with better sovereign credit ratings benefiting from higher values.
On the positive side, in countries where resolution practises were tightened and bank debtholders involved in the burden-sharing, the values of implicit guarantees for many banks, declined. In that sense, actions speak louder than words. Examples are rare, however, and did not involve large banks. In countries where smaller banks have been resolved and debtholders involved in the burden sharing, the values of implicit bank debt guarantees tended to decline. Not so for globally systemically important banks.
This observation is somewhat disturbing. Part of the overall financial reform package consists of identifying, based on an internationally agreed methodology, so-called “global systemically important banks” (G-SIBs), and then subjecting these banks to a more constraining and restrictive regulatory, supervisory and failure resolution regime. The G-SIB approach might, in principle, have two opposing effects. On the one hand, the additional regulatory, supervisory and failure resolution failures requirements might make the concerned banks more stable and more easy to resolve should they experience substantial stress. The probability of distress would decline together with the probability of bail-out if in distress. This is the desired effect. On the other hand, in identifying some banks as different from others by including them in a list of banks considered to constitute a greater risk to the financial system in the event of failure, the perception that these banks are “too big to fail” might become further entrenched. In other words, the probability of bail-out if in distress would increase. This would be an undesirable effect.
It turns out that although there has been some overall progress in reducing the perception of government support for large banks worldwide, the “G-SIB approach”—identifying and then subjecting to special treatment a subset of banks that are considered to pose a particular threat to global financial stability – has not been effective. The liabilities of G-SIBs continue to benefit from a higher level of government support assumption than those of other banks. One interpretation is that there has been no practical experience with the resolution of a G-SIB in practise and that resolution regimes for G-SIBs are not yet fully credible. For example, the credibility of the so-called “living wills” intended to render the default of these institutions manageable and submitted by the banks themselves has been questioned by regulators.
Thus, despite the strengthening of banks as well as of the apparatus to allow unviable ones to exit markets smoothly, implicit guarantees for some types of bank debt continue to have positive values. Moreover, by labeling some banks as systemically important, the perception that these banks benefit from an implicit bank debt guarantee might have become further entrenched. In that regard, the system might not have become fairer.
Footnotes
[1] Schich, Sebastian (2018). Implict Bank Debt Guarantees: Costs, Benefits and Risks. Journal of Economic Surveys (2018) Vol. 32, No. 5, pp. 1257–1291.
[2] FSB. (2017). Safer, simpler, fairer: G20 reforms explained. Financial Stability Board, 3 July.
Sebastian Schich is Principal Economist in the Directorate for Financial and Enterprise Affairs of the OECD.
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