Banking on a crisis and on its resolution

The recent financial crisis has left a hole in the public finances of many countries. Yet, with the right preparation, governments may have been better placed to fund that gap. This holds lessons for future crisis resolution strategies.

The worst crisis of our lifetimes should never be allowed to happen again. How often has this refrain been heard since Lehman Brothers crashed in 2008, taking much of the global financial sector with it?

Governments dug deep to save financial markets–“the lifeblood of our economic systems” as some put it–as taxpayers and savers looked on in disbelief: how could we have let it go so far? Many people have tried to answer this question, and the debate is a passionate and divisive one.

What no one disagrees on is that the crisis has been costly. In 2010 the IMF estimated the fiscal costs of direct support, net of recovered amounts, at some 2.8% of GDP for the advanced G20 countries. But these costs probably underestimate the total impact, which will be reflected in much higher debt: OECD public debt is now over 100% of GDP, compared with over 70% in 2007. Also, there have been major losses in jobs and output.

While it is too early to assess the full cost of the latest crisis, as history shows, financial crises are a recurrent event. So it is likely they will happen again. To be sure, new and improved rules will be introduced, and will hopefully limit the frequency and severity of future crises, but such is the nature of our system that occasional breakdowns will occur. There could, for instance, be overleveraging again, as borrowers get in over their heads, or as lenders, awash with cash, relax the rules in a bid to get their money working again.

Beyond the swings and roundabouts of financial markets, there is another clear lesson, which is that governments should be far better prepared financially for crises than they appeared to be in 2008. Far too many of them were caught napping, in terms of assessing the gravity of their own situations and in responding to the problem at hand. In fact, the entire response was based on reacting after the horse had bolted. These ex-post responses, while to some extent inevitable in any crisis, are ad hoc and costly.

Public authorities could be better prepared beforehand too, say, by storing up money in the kitty as a buffer, if not to prevent the crisis, then at least to reduce the size of the bill associated with resolving it. The effective funding of systemic crisis resolution will remain an issue, even if considerable progress is achieved in reducing systemic risks. This crisis has highlighted the existence of very wide ex-ante funding gaps in this regard.

More extensive use of ex-ante rather than ex-post funding for crisis resolution strategies would be complementary to current efforts to oblige banks to build up larger buffers of capital during good times, as a defence against future market shocks.

Good fiscal policies should also reflect ex-ante principles. True, several OECD countries did not start into the crisis from positions of strength, with wide fiscal deficits and public debt reaching or exceeding 100% of their gross domestic product. Those imbalances worsened in the crisis.

But some governments started out in far better positions than that. Take Ireland. In 2007 its general government finances were in surplus to the tune of nearly 3% of GDP in 2006, while its overall government debt was below 30% of GDP. Its unemployment rate was one of the OECD’s lowest too. On the face of it, the country looked prepared. But when the crisis began to bite, even Ireland found that it could do little other than to provide a blanket guarantee for creditors and depositors. This had the effect of shifting bank sector risks and associated losses on to sovereign balance sheets.

Addressing current fiscal challenges and gaps is not enough, however. For unless advanced action is taken to set money aside for the future, a systemic funding gap will embed itself into the system. That means countries will go forward again underprepared until the next, possibly worse, crisis strikes.

Moreover, given the causes of the crisis, the financial sector should play a fuller part in helping to build up ex-ante funds. As the G20 put it in their declaration at the Toronto Summit in June 2010, “the financial sector should make a fair and substantial contribution towards paying for any burdens associated with government interventions, where they occur, to repair the financial system or fund resolution, and reduce risks from the financial system.”

Taxation is an obvious way of doing this. So far, any tax initiatives taken since the crisis broke were designed mainly to raise revenue in somewhat trying circumstances. Some were aimed at the financial sector, and some levies, in France, Italy and the UK, for instance, targeted large bank bonuses, with obvious political as well as economic intentions of getting the “fat cats” to pay their fair share. Did these measures work?

Yes and no. One high-profile example is the UK. Its tax, which expired in April 2010, was a one-off surcharge payable by banks equivalent to 50% of discretionary bonus payments above a specific threshold. The UK Treasury intended it as a way “to encourage banks to consider their capital position and to make appropriate risk adjustments when setting the level of bonus payments above the threshold.” With City bonuses again ballooning as the crisis keeps its grip on the UK economy, the tax was not deemed very successful in changing behaviour. That said, it did raise welcome revenues for the exchequer.

Taxation is a tricky area, even if the aim is to recoup funds. There may be concerns about double-taxation for instance, or losing competitiveness, or indeed, penalising good banks and institutions that had nothing to do with the crisis, and whose proper management helped them survive the crisis in the first place. Setting taxes on financial institutions at relatively high levels could cause subsidiaries of foreign banks to reduce their activities altogether. Also, care is needed in taxing any single sector, since tax reforms have to be carried out in such a way as to maintain an effective overall tax structure.

Nevertheless, looked at closely, many tax officials feel that tax regimes affecting financial sectors in most OECD countries could do with some tweaks, since they tend to favour raising debt over, say, equity financing. Others believe that financial sector activities are under-taxed anyway, compared to manufacturing, for instance, partly because the application of value-added taxes to the financial sector is fraught with complications. In any case, the issue is not just to close current funding gaps that have opened up during this crisis, but to prepare for the future.

New insurance approaches?
While schemes for insuring retail deposits exist in almost all OECD countries, systemic crises are not meant to be dealt exclusively with such arrangements. The recent crisis merely confirms that such arrangements are ill-equipped to absorb shocks of the magnitude we have just experienced.

Against this background, policymakers have been looking to the example of catastrophic risk insurance, such as for terrorism, nuclear accident risk and other emergencies, to see if models could be emulated there. Several OECD countries have already established specific public-private risk sharing arrangements for catastrophic events at the national level. This structure typically involves a first layer of funding consisting of deductibles and self-insurance by the private sector, and a top layer provided by the government. Other layers include insurance and reinsurance. Capital markets may also be involved through the issuance of catastrophe bonds.

But there are issues to consider with this approach. For a start, while financial market crises are man-made, not natural, disasters, they do share a common main problem, insofar as the insurance (and reinsurance) capacity is ultimately limited. Moreover, the financial management challenges of covering the risks of market meltdowns would be enormous, not least because of the sheer magnitude of the potential exposure. And as for averting crises, while moral hazard is not an innate flaw of insurance solutions, the very existence of catastrophic insurance for the financial sector could in theory encourage moral hazard, leading to more reckless borrowing and lending, not less.

Policy leaders
While it is difficult to say how much ex-ante funding would be needed to resolve a future systemic financial crisis, some governments are determined to find out. Germany, for instance, has passed a law on bank restructuring, which includes establishing a restructuring fund. The main aim of the law is to ensure the resolvability of any bank, including systemically important ones, while avoiding any major disruption to the wider economy. The law came into effect at the end of 2010, and will be monitored with great interest in Germany and abroad.

Perhaps the approach being watched most closely is Sweden’s, precisely because of its funding aspect. Rather in the spirit of the oilrelated investment fund which neighbouring Norway set up for future pensions in the 1990s, Sweden introduced a “stability levy” in 2009. Basically, it’s an annual tax of 0.036% on most of a bank’s liabilities, with the proceeds earmarked for a “stability fund”. The aim is to build up funding to the tune of 2.5% of GDP within 15 years. This not-insignificant fund is intended to help to address disturbances in the financial system, though it will not obviate the need for developing effective rules for ex-post burdensharing. Still, it will provide that extra cushion which taxpayers appreciate and which could limit the negative impact of the next crisis. Very importantly, such crisis resolution funds would help to sever the link between the sovereign authorities and the domestic banking sector, a link which turned out to be so problematic in the case of Ireland and some other countries in the recent financial crisis.

Sweden’s proactive initiative has attracted widespread attention. The IMF now suggests that, by accumulating taxes over a decade, such “crisis resolution” funds should aim for 2-4% of GDP. Such a fund would be attractive to many voters, particularly if the financial sector was seen to be contributing its fair share.

But even ex-ante funding is not a silver bullet for ending a crisis. Nor would it likely cover all the costs, as these vary so wildly that they cannot be foreseen with any real certainty: consider Indonesia’s 1997 crisis, which cost nearly 60% of its GDP, or Finland’s at the start of the 1990s which cost some 14% of GDP. That’s roughly the estimate of the latest crisis for Iceland and the Netherlands.

All this said, some ex-ante funding to bridge inevitable funding gaps would be better than nothing at all and would at least reduce sovereign liabilities. Even minor benefits like this should not be underestimated, given the impending cost pressures of the likes of ageing, healthcare and climate change.

Crises will undoubtedly happen again, but building some kind of ex-ante fund towards their resolution, whether along Swedish lines or some other approach, may at least instil some “stability” in an otherwise unstable situation. That, in itself, makes it a policy worth considering.


References

Schich, Sebastian and Byoung-Hwan Kim (2010), “Systemic Financial Crises: How to Fund Resolution”, in Financial Market Trends, Volume 2010, Issue 2, OECD, Paris G20 Toronto Summit Declaration, 27 June 2010, Available at http://www.oecd.org/dataoecd/16/16/46681329.pdf

HM Treasury (2010), Budget 2010, Chapter 3: “Reforming Financial Services”, 24 March, see www.direct.gov.uk


©OECD Observer No 284, Q1 2011




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