28 May 2012

Bank of England: Financial Stability Paper No 15 - The implicit subsidy of banks

This paper examines the implicit subsidy of UK banks by the government, and the associated distortions in the financial system. It explains why the subsidy arises and why it is a public policy concern, and explores how it can be quantified.

Quantifying the implicit subsidy to banks has generated considerable interest over recent years. 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)). This paper explains the divergence between these estimates, examines their dependence on differing underlying assumptions, and proposes a new alternative means of quantification.

Implicit subsidies arise from a fundamental distortion in the financial system: the costs of bank distress are so large that the authorities have been unable to commit credibly not to intervene to prevent their failure. Creditors perceived this and reduced the compensation they demanded for bearing banks’ risk. This causes a deadweight loss as banking crises — and their associated loss of welfare — become more frequent. The extent to which outcomes are distorted is directly related to the size of the subsidy, which is why measurement of its size is useful.

Initiatives such as the structural reforms recommended by the Independent Commission on Banking, extra prudential requirements for globally systemically important banks, resolution planning and ongoing efforts to improve the loss-absorbency of debt instruments will reduce the extent to which authorities intervene in the future to prevent bank failures.

The paper has explored estimates of the implicit subsidy in the existing literature, and shown how the divergence between them depends on their differing modelling assumptions and information content. 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.

Full Financial Stability Paper

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