Sunday, June 17, 2012

The implicit subsidy of banks

by Joseph Noss and Rhiannon Sowerbutts


June 17, 2012

A credible threat of failure is an integral part of any industry. But this does not always apply to banks as failure may result in unacceptable economic costs. As a result, 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 our paper (Noss and Sowerbutts 2012) is to set out the two main approaches, their merits, and propose a new method of estimation.


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