17 June 2012

Noss/Sowerbutts: The implicit subsidy of banks

Unprecedented amounts of public money have been used to avert bank failure. This column explains why the subsidy arises, why it is a public policy concern, and how it can be quantified.

The experience of the crisis has revealed that a credible threat of failure does not always exist for banks. While equity holdings were severely diluted through state intervention, debt holders of some failed banks did not incur losses and were guaranteed by governments. To the extent that neither banks nor their creditors paid for this guarantee, it can be considered an implicit subsidy.

The implicit subsidy of banks represents a transfer of resources from one set of agents — the government (and ultimately taxpayers) — to the financial sector. The distribution of the benefits depends on the underlying competitive structure of the banking industry, scarcity of its resources and the precise nature of the change in incentives that the subsidy induces. But it seems likely that bank creditors, customers, staff and shareholders all benefit to some degree, at the expense of taxpayers.

Quantifying the implicit subsidy to banks has generated considerable interest. The numbers are striking, both in their sheer scale, but also in their variation. Estimates of the implicit subsidy to major UK banks vary from around £6 billion (Oxera 2011) to over £100 billion (Bank of England 2010). The key contribution of this paper is to set out the two main approaches, their merits, and propose a new method of estimation.

Conclusion

The range of results from using funding advantage and two types of contingent-claims methods reflects their relative strengths and the information on which they draw. Funding advantage approaches rely on subjective ratings-agency judgement to determine the likelihood of bank failure and the probability of the extension of government support. In contrast, the contingent-claims approach bases this estimate of the likelihood of bank failure and support on information from financial-market prices, and make the simplifying assumption that banks fail when assets fall to a value commensurate with banks’ minimum capital ratios, leading to the extension of government support.

Neither approach provides a perfect measure of the subsidy. Finding a definitive measure of the subsidy is frustrated due to its terms, and lack of observable price. But despite their differences, all measures point to significant transfers of resources from the government to the banking system.

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