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Banking on the State: USD 14 trillion

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The scale of intervention to support the banks in the UK, US and the euro-area during the current crisis totals over $14 trillion or almost a quarter of global GDP. It dwarfs any previous state support of the banking system. These interventions have been as imaginative as they have large, including liquidity and capital injections, debt guarantees, deposit insurance and asset purchase.

A Bank of England report (by Alessandri and Haldane) analyses over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises. But for at least the past century the pendulum has swung back, with the state often needing to dig deep to keep crisis-prone banks afloat.

Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction.

 

 

 

The costs of the interventions are already being felt. As in the Middle Ages, perceived risks from lending to the state are larger than to some corporations. The price of default insurance is higher for some G7 governments than for McDonalds or the Campbell Soup Company. Yet there is one key difference between the situation today and that in the Middle Ages. Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks.

Causality has reversed.

State support is one side of the “social contract” between banks and the state.

State regulation of banks is the other. The terms of this social contract have recently worsened. That should come as no surprise. At least over the pastcentury, there is evidence of a ratchet in the scale and scope of state support of the banking system. Whenever banking crises strike, the safety net has bulged. Like over-stretched elastic, it has remained distended.

What explains this ratchet? All contracts are incomplete.

Contractual relationships, like personal ones, often break down due to commitment problems. Social contracts between the state and the banks are no exception. This generates a time-consistency problem for the authorities when dealing with crisis – a tendency to talk tough but act weak. This explains historical hysteresis in the safety net.

So what can be done?

There are many reform proposals on the table.

Two sets of initiative are discussed here: changes to the regulation of banks’ risk-taking; and changes to the terms of the social safety net to improve its time-consistency. It is too early to know whether these measures will be sufficient. But recent events suggest some mix of these measures is surely necessary.

Read the whole report here (including some interesting graphs by the end).

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