Report on Safety-Net Benefits Conferred on TBTF Banks

In a post at vox.eu, Santiago Carbó-Valverde, Edward J Kane, and Francisco Rodríguez Fernández introduce their NBER working paper, Safety-Net Benefits Conferred on Difficult-to-Fail-and-Unwind Banks in the US and EU Before and During the Great Recession, which "models and estimates ex ante safety-net benefits at a sample of large banks in US and Europe during 2003-2008. They report that "our results suggest that difficult-to-fail and unwind (DFU) banks enjoyed substantially higher ex ante benefits than other institutions."

This result suggests that current practice increases moral hazard and creates an incentive to undertake excess risk and misprice risk. It also disadvantages banks of lesser size and political clout that do not enjoy this benefit. It also presumes upon public finance in the expectation of preferential treatment owing to systemic risk, which creates a kind of aristocratic privilege. The authors summarize:

Accounting standards for recognising losses make it hard to detect if a bank is going under. The signs of a bank’s insolvency are slow to surface. During the housing and securitisation bubbles that preceded the 2007-2008 financial meltdown, top managers and regulators of US and EU financial institutions claimed that there was no way they could see the build-up of crisis pressures.

Moreover, as the crisis unfolded, these same officials failed to offer timely estimates of the financial and distributional costs of bailing out firms that benefited from open-bank assistance. The result is simple.

• These observational difficulties encourage firms that are large, complex, and politically powerful to plan to shift their deepest downside risks onto taxpayers through the financial safety net.

• The predictability of officials’ panicky willingness in crisis situations to acquiesce in these plans gives banking organisations that are difficult to fail and difficult to unwind what can be termed a “taxpayer put”.

Unless it is perfectly administered and adequately priced, this put supplies intangible capital to every firm that safety-net managers may be expected to protect.

Although these taxpayer puts do not trade directly, contingent-claims analysis offers several ways to estimate their value synthetically from the stock prices of individual systemically-risky firms.

While MMT shows that taxpayers do not fund bail-outs directly, as the authors suggest, since a monetarily sovereign government funds itself with currency issuance rather than taxation, MMT agrees that this does divert public funds from other uses for public purpose, and it constitutes a subsidy to a particular industry segment, owing to its ability to hold the government hostage because of its importance to the economy and political influence.

The authors reject the excuse of regulators that the situation with large banks was too complicated for them to be able to foresee insolvency problems. They conclude that transparency reduces the problem, and that capture, which they label corruption, accounts for ensuing government rescues. The authors conclude:

A useful first step would be to require bank managers to report data on earnings and net worth more frequently – under civil or even criminal penalties for fraud and negligent misrepresentation if they do not. Data on market capitalisation are publicly available in real time, as are data on stock-market returns. If the values of on-balance-sheet and off-balance-sheet positions were reported weekly or monthly to national authorities, rolling regression models could be used to estimate changes in the flow of safety-net benefits in ways that would allow regulators to observe and manage taxpayers’ stake in the safety net in a more timely and effective manner.

UPDATE: To be read in conjunction with William K. Black, Why we need regulatory cops on the beat - and why they make bankers cringe. Prof. Black shows why reporting is not enough. Strict regulation, oversight, and enforcement are required in environments in which fraud is endemic.