Government guarantees for financial institutions are a financial crisis thing, right?
Wrong.
As the above chart from a new OECD paper (by Sebastian Schich and Byoung Hwan Kim) shows, guarantees were proliferating well before the credit crunched years of 2007 to 2008. Not, however, that the guarantees weren’t without controversy even before their crisis-induced proliferation.
The paper details, for instance, the different approaches taken by Australia and the United States. Up until very recently, the US and Australia were basically at opposite ends of the financial insurance spectrum. In the States, government-supported guarantee arrangements for depositors, pension fund beneficiaries and mortgage pools abounded. Australia, meanwhile, didn’t even have deposit insurance until after the recent crisis. Australia had issued a report in 1997 concluding that guarantees were harmful to the financial system because they fostered moral hazard. (Now, of course, Australia is one of the few OECD countries, alongside Ireland and Iceland, to have unlimited deposit insurance).
So why would governments choose to put in place guarantees? For a start things like deposit insurance do a decent job of boosting confidence in what is essentially a confidence reliant industry — banking. Stuff like credit guarantees, meanwhile, can help boost loan access for small businesses.
And then there’s also this:
Guarantee arrangements have become a policy intervention mechanism of choice in some parts of the financial sector. One of the attractive features of such arrangements is that they require limited, if any, upfront fiscal outlays. Moreover, to the extent that the risks covered do not materialise, fiscal costs will never arise, at least not as a direct consequence of the provision of the guarantees. Thus, to influence credit allocation and to avoid that shocks to financial institutions propagate and affect the broader economy, policy makers have encouraged the development of guarantee arrangements regarding many types of financial claims, although specific country choices have differed in this regard.
Government guarantees of the financial system tend to be fine, until the financial system goes bust and the guarantees are actually required. They are essentially a giant bluff strategy by governments.
Of course, once guarantees are called upon then suddenly the state is lobbed with a whole host of contingent liabilities. Contingent liabilities which, post the financial crisis, now look like this:
It’s worth pointing out here, as the OECD authors do, that while some contingent liabilities seem well understood by market participants — others, not so much. The ratings agencies, for instance, apparently don’t factor in the liabilities of pension funds when rating sovereigns.
Here are the authors, again:
The financial crisis has shown, however, that government support will be extended for specific financial claims, regardless of whether any explicit government support had previously existed. This problem exists because potential political pressures and/or concerns about systemic, social and other consequences tend to lead governments to provide State support beyond whatever their explicit commitments might have been. To avoid situations in which the balance sheet problems of financial institutions spill-over to the sovereign through such mechanisms, a considerable degree of ex ante funding of guarantee arrangements to cover claims on these financial institutions (or those held by them) is necessary. The experience during the recent systemic crisis suggests that ex ante-funded systemic crisis resolution arrangements, together with strengthened failure resolution powers, are helpful in limiting the overall cost of crisis resolution … Similarly, the more extensive the ex-ante funding for guarantees on financial claims, the weaker the effect that financial institutions’ balance sheet problems should have on sovereign credit risk.
No surprise the authors conclude that “the net of government-supported guarantees for financial promises cannot be expanded without limit” and any guarantees that are offered need to be genuinely affordable.
The full paper is well worth a read.
Related links:
Going for broke with bank guarantees – FT Alphaville
Thou shalt not bluff - FT Alphaville
Stress tests sovereign support = senseless – FT Alphaville
Credit distortion de crise – FT Alphaville