Andrew G Haldane: Banking on the state
Paper by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England,
and Mr Piergiorgio Alessandri, based on a presentation delivered at the Federal Reserve
Bank of Chicago twelfth annual International Banking Conference on "The International
Financial Crisis: Have the Rules of Finance Changed?", Chicago, 25 September 2009.
Contributions and comments were provided by Paul Doran, Marius Jurgilas, Samuel Knott, Salina Ladha, Ouarda
Merrouche, Filipa Sa, William Speller, Matthew Willison and Nick Vause.
* * *
1. Introduction
Historically, the link between the state and the banking system has been umbilical. Starting
with the first Italian banking houses in the 13th century, banks were financiers of the
sovereign. Sovereign need was often greatest following war. The Bank of England was
established at the end of the 17th century for just this purpose, financing the war debts of
William III.
From the earliest times, the relationship between banks and the state was often rocky.
Sovereign default on loans was an everyday hazard for the banks, especially among states
vanquished in war. Indeed, through the ages sovereign default has been the single biggest
cause of banking collapse.1 It led to the downfall of many of the founding Italian banks,
including the Medici of Florence.
As awareness of sovereign risk grew, banks began to charge higher loan rates to the
sovereign than to commercial entities. In the 15th century, Charles VIII of France paid up to
100% on war loans to Italian banks, which were at the same time charging Italian merchants
5-10%.2 The Bank of England's first loan to government carried an interest rate of 8% -
double the rate at which the Bank discounted trade bills.
For the past two centuries, the tables have progressively turned. The state has instead
become the last-resort financier of the banks. As with the state, banks' needs have typically
been greatest at times of financial crisis. And like the state, last-resort financing has not
always been repaid in full and on time. The Great Depression marked a regime-shift in state
support to the banking system. The credit crisis of the past two years may well mark another.
Table 1 provides a snap-shot of the scale of intervention to support the banks in the UK, US
and the euro-area during the current crisis. This totals over $14 trillion or almost a quarter of
global GDP. It dwarfs any previous state support of the banking system. These interventions
have been as imaginative as they have large, including liquidity and capital injections, debt
guarantees, deposit insurance and asset purchase.
The costs of this intervention are already being felt. As in the Middle Ages, perceived risks
from lending to the state are larger than to some corporations. The price of default insurance
is higher for some G7 governments than for McDonalds or the Campbell Soup Company. Yet
there is one key difference between the situation today and that in the Middle Ages. Then,
the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the
sovereign comes from the banks. Causality has reversed.
State support is one side of the "social contract" between banks and the state.3 State
regulation of banks is the other. Table 1 suggests that the terms of this social contract have
recently worsened. That should come as no surprise. At least over the past century, there is
evidence of a ratchet in the scale and scope of state support of the banking system (Section
2). Whenever banking crises strike, the safety net has bulged. Like over-stretched elastic, it
has remained distended.
What explains this ratchet? All contracts are incomplete.4 Contractual relationships, like
personal ones, often break down due to commitment problems. Social contracts between the
state and the banks are no exception. This generates a time-consistency problem for the
authorities when dealing with crisis - a tendency to talk tough but act weak. This explains
historical hysteresis in the safety net (Section 3).
So what can be done? There are many reform proposals on the table.5 Two sets of initiative
are discussed here: changes to the regulation of banks' risk-taking; and changes to the terms
of the social safety net to improve its time-consistency. It is too early to know whether these
measures will be sufficient. But recent events suggest some mix of these measures is surely
necessary.
2. Evolution in the banking safety net
The three longest standing state insurance devices for the banking system are liquidity
insurance, deposit insurance and capital insurance. These offer protection to different parts
of banks' capital structure, respectively wholesale deposits, retail deposits and equity. So
how have risks to banks' balance sheets - in effect, the "insurable interests" of the state -
evolved over time? And how, in turn, has this evolution shaped the design of the banking
safety net?
The UK provides a useful historical case study. Chart 1 plots UK banks' balance sheet
against GDP since 1880. The ratio is flat for almost a century, at around 50%. Over this
period, banks' assets grew roughly in line with money spending. But from the early 1970s,
this pattern changed dramatically. By the start of this century, bank balance sheets were
more than five times annual UK GDP. In the space of a generation, the insurable interests of
the state had risen tenfold.
By itself, this expansion of balance sheets need not imply that the state was bearing greater
implicit risk. For example, banks could have self-insured by holding larger buffers of capital
and liquidity. In practice, the opposite happened (Charts 2 and 3). Capital and liquidity ratios
have fallen secularly in the UK and US for over a century.
Since the start of the 20th century, capital ratios have fallen by a factor of around five in the
US and UK. Liquidity ratios have fallen by roughly the same amount in half that time. Taken
together, these balance sheet trends indicate a pronounced rise in banking system risk and
hence in potential demand for state insurance. They have also affected the returns required
by bank shareholders.
As banks moved up the risk spectrum, the return required by shareholders has predictably
increased. Between 1920 and 1970, the return on UK banks' equity averaged below 10% per
annum, with low volatility of around 2% per year (Chart 4). This was roughly in line with risks
and returns in the non-financial economy.
The 1970s signalled a sea-change. Since then returns on UK banks' equity have averaged
over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to
higher return is higher risk. And so it was, with the volatility of UK banks' returns having
trebled over the past forty years.
This regime shift upwards in the risk and return profile of UK banks can be explained by the
fall in their capital ratios. Higher leverage boosts required returns on equity because it
simultaneously makes the banking system's balance sheet more fragile. There is unlikely to
be a better case study of these dynamics at play than events over the past decade.
So how has the state's safety net evolved in response? The element of the safety net with
liquidity
the longest historical pedigree is insurance, typically provided by the central bank in
the form of last resort lending. The principles behind last resort lending were first articulated
by Henry Thornton at the beginning of the 19th century and were subsequently elaborated by
Walter Bagehot.6
Last resort lending in practice was often rather less elegant than the theory. Writing at the
time of the 1825 banking crisis, Jeremiah Harman, Director of the Bank, described it thus:
"We lent [money] by every possible means and in modes we have never
adopted before; we took in stock on security, we purchased Exchequer
bills, we made advances on Exchequer bills, we not only discounted
outright, but we made advances on the deposit of bills of exchange to an
immense amount, in short, by every possible means consistent with the
safety of the Bank...Seeing the dreadful state in which the public were, we
rendered every assistance in our power."7
Chart 5 plots the Bank of England's balance sheet in relation to GDP since 1830. Stripping
out the effects of the two World Wars, this ratio has declined fairly steadily, from around 15%
in 1830 to around 5% at the start of this century. Financial panics over this period did little to
interrupt the downward trend.
Events of the past two years have dramatically altered that picture. In relation to GDP, base
money in the UK has risen by a factor of four - easily the highest financial crisis multiplier
ever.8 It has reached a peak last witnessed almost two centuries ago. Past liquidity crises
are foothills by comparison with recent Himalayan heights.
Measures of central bank balance sheet expansion under-estimate the scale of liquidity
support provided during this crisis. As in Harman's time, there has been a widening of the
collateral taken by most central banks in their operations.9 The taking of imaginative forms of
collateral has a history which predates central banking: in the 12th century, King Baldwin II of
Jerusalem secured a loan using his beard as collateral. Nonetheless, recent efforts are
probably unprecedented in scope.
Collateral swaps, typically not involving beards but often requiring haircuts, have also played
a significant role during this crisis. They too do not expand base money, but do liquefy banks'
balance sheets. And guarantees of wholesale liabilities have similarly served as an important
liquidity insurance device for a number of countries. Together, these two instruments have
totalled between 10% and 40% of GDP across the UK, US and euro-area.
Plainly, there has been a dramatic expansion in both the scale and scope of state liquidity
insurance to the banking system. This pattern has been repeated in the majority of recent
systemic banking crises. In a study of 42 systemic banking crises between 1970 and 2007,
Laeven and Valencia find peak liquidity provision of almost 30% of total deposits. Drastic
times clearly call for drastic measures. Harman's description of last resort lending in 1825
would not look out of place today. Except, crucially, the decimal point would have changed
place.
Deposit insurance capital insurance
and have a shorter history. Deposit insurance was first
introduced in the US in 1934, to protect retail depositors scorched by the experience of the
Great Depression. It failed to catch on internationally. By the early 1960s, the US was still the
only developed country with an explicit deposit insurance scheme. Since then, there has
been a steady rise in the number of adopting countries (Chart 6). By 2009, almost 100
countries globally had such a regime.
Typically, the introduction and extension of deposit insurance regimes has been a response
to banking crisis. This time's crisis has been no exception. Australia and New Zealand have
both introduced deposit guarantee schemes. And more than forty countries have increased
the coverage limits of their existing schemes, including in the UK, US and Germany. In a few
countries, deposit insurance limits have temporarily been removed - for example, in
Germany and Ireland. In many others, they have been removed implicitly.
This, too, is a familiar pattern at crisis time. Laeven and Valencia find that coverage limits for
deposit insurance schemes on average increase fourfold in relation to GDP after systemic
crises.10 As with liquidity insurance, there has been a secular expansion in the scope and
scale of deposit insurance.
Finally, explicit capital insurance of the banking system appears to have been a more recent
phenomenon. In the US, the Reconstruction Finance Corporation was established in 1932 at
the height of the Great Depression; it played a key role in recapitalising US banks through
injections of preferred stock. More recently, recapitalisation of the banks has accompanied
the banking crises in Scandinavia, Japan, Asia and Latin America.
Historically, capital injections into the UK banking system have tended to be small and
bespoke - for example, at the time of the secondary banking crisis in the 1970s and the
small banks crisis in the early 1990s (Table 2).11 In terms of scale, capital injections during
this crisis knock these interventions into a cocked hat. Once again, the decimal place has
changed place. This pattern is replicated in studies of recent systemic banking crises. Since
the 1970s, capital injections to the banking system have averaged around 8% of GDP at
crisis time.12
Taken together, this evidence paints a consistent picture: a progressive rise in banking risk
and an accompanying widening and deepening of the state safety net. There is a ratchet.
This ratchet is evidence of a policy time-consistency problem.
3. Time-consistency and the banking safety net
What explains this time-inconsistency? A simple framework is developed to explain the
existence of, and ratchet in, the safety net. It focuses on the incentive structures facing
owners of banks and the risk strategies they pursue. The run-up to the present crisis
provides several examples of those incentives and strategies at work.
Take the payoff profile facing a bank shareholder. Assume that the sensitivity of the bank's
assets to aggregate risk - in the language of finance, its beta - equals 0.1. So for every 10%
movement in the market as a whole, the bank's assets move by 1%. Assume too that the
beta of the bank's deposits is zero and that the bank has an equity capital ratio of 10%. While
arbitrary, these numbers are broadly plausible. Conveniently, under those assumptions the
beta of the bank's equity equals one. Figure 1 shows the payoff profile facing owners of the
bank.
The return on a bank's equity lies on a 45 degree line when market returns are positive.
Gains to shareholders are potentially unlimited. But the same is not true in bad states of the
world. The reason is limited liability. That constrains the losses of shareholders to around
zero. Losses beyond that point are borne by other parts of banks' capital structure -
wholesale and retail depositors. Therein lies the problem.
If protection of depositors is felt to be a public good, these losses instead risk being borne by
the state, either in the form of equity injections from the government (capital insurance),
payouts to retail depositors (deposit insurance) or liquidity support to wholesale funders
(liquidity insurance). The gains risk being privatised and the losses socialised. Evidence
suggests this is a repeated historical pattern.
Socialised losses are doubly bad for society. Taxes may not only be higher on average. They
may also need to rise when they are likely to be most painful to taxpayers, namely in the
aftermath of crisis. So taxes profiles will be spiky rather than smooth and will spike when the
chips are down. This is the opposite to what tax theory would tells us was optimal.13
So far, so bad. But it is about to get worse, for this tells only half the story. This is a repeated
game. State support stokes future risk-taking incentives, as owners of banks adapt their
strategies to maximise expected profits. So it was in the run-up to the present crisis. In
particular, five such strategies were clearly in evidence:
•
Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising
from limited liability is to increase leverage. For example, if the capital ratio of the
hypothetical bank were to halve from 10% to 5%, the beta of the bank's equity would
double (Figure 2). In that event, the imbalance between privatised gains (above the
zero axis) and socialised losses (below the zero axis) would increase. Private
investors would harvest more of the upside and export more of the downside.
There is clear evidence of this strategy being pursued over long sweeps of history
(Chart 2). Chart 7 looks at the behaviour of UK banks over the past decade; it plots
their leverage against the riskiness of their assets. UK banks migrated North-West
over the past ten years, with balance sheet expansion financed by higher leverage.
Because UK and European banks were not subject to any regulatory restriction on
simple leverage, there was no effective brake on this leverage-fuelled expansion.
Higher leverage fully accounts for the rise in UK banks' returns on equity up until
2007. It also fully accounts for the subsequent collapse in these returns. The
highleverage strategy pursued by UK and European banks rather effectively privatised
gains and socialised losses.
•
Higher trading assets: An alternative means of replicating the effects of higher
leverage is to increase the proportion of assets held in banks' trading books. Trading
assets are marked to market prices, thereby increasing their sensitivity to aggregate
market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets
in the banking book (with a beta of zero) and the remainder in the trading book (with
a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1).
But if the size of the trading book is doubled to 20% of assets, this doubles the
equity beta of the bank (Figure 2).
Chart 8 plots a cross-section of global banks' trading assets as a fraction of their
total assets against their leverage. It suggests that efforts to expand balance sheets
through higher leverage were focussed on trading assets. In the first part of this
decade, rising asset prices delivered mark-to-market gains on banks' expanding
trading assets. This boosted their profitability and returns on equity. As long as asset
prices rose, this created an Alice in Wonderland world in which everybody had won
and all had prizes.
But when asset prices fell, reality returned. The same institutions suffered enormous
mark-to-market trading book looses. Across global banks, trading book losses since
the start of the crisis total over $900bn. In a number of cases, these losses
necessitated state support. Trading book expansion also allowed banks to import
the upside and export some of the downside.
•
Business line diversification: A third strategy pursued by many financial institutions
in the run-up to crisis was diversification of their business lines. For banks
individually, this made sense. It helped reduce the idiosyncratic risk from individual
business lines. Pre-crisis, this strategy seemed the epitomy of sound banking.
In fact, it epitomised Keynes' description of a sound banker: "one who, when he is
ruined, is ruined in a conventional and orthodox way with his fellows, so that no-one
can really blame him".14 Because, for risk across the system as a whole, this
strategy has systemically dangerous consequences. By increasing the similarity of
banks' asset portfolios, it increases the system's sensitivity to aggregate
fluctuations. Although diversification may purge idiosyncratic risk, it simultaneously
reduces diversity and thereby increases systemic risk.15 It, too, increases the risk of
adversity being socialised and prosperity privatised.
•
High default assets: A fourth strategy for exploiting the asymmetry of equity payoffs
is to originate assets which themselves have asymmetric returns. High risk loans are
one example. These assets yield a high fixed payoff in good states of the world, but
in bad states default generating large losses. Because losses are bunched in the
tail, the result is that more of the gain is privatised and more of the loss socialised
(Figure 3).
This was the strategy pursued by US banks in the run-up to crisis. Unlike banks in
Europe, US banks were effectively constrained from expanding their balance sheet
by a regulatory leverage ratio. So instead they did the next worst thing: they sought
higher return on equity by increasing the riskiness of their asset pool. This explains
their venture into sub-prime and leveraged lending and various kinds of securitised
exotica.
Chart 9 looks at the leverage and risk positions of European versus US banks.
European banks lie in the North West, as they exploited the absence of a leverage
constraint to expand their balance sheets in search of higher return on equity. US
banks, by contrast, located themselves in the South-East with lower leverage but
higher risk per unit of assets. For US banks, this was a best response strategy for
boosting shareholder payoffs. When risk on these high-default assets materialised,
however, the result was the same as for European banks - deep losses, often
cushioned by the state.
•
Out-of-the-money options: The payoffs to high-risk lending can be replicated using
an alternative strategy of writing deep out-of-the-money options. This can be
achieved, for example, by selling protection in the CDS market. The writer of that
protection receives an insurance premium and thus a steady source of income in
good states of the world. Because of that, this strategy appears to generate "alpha"
- excess returns - during the good times.
In fact, this strategy is a wolf wrapped in sheep's clothing; it is beta dressed up as
alpha. In the event of a bad state of the world - default by the reference entity in a
CDS context - the writers of the insurance suffer a significantly negative payoff,
eliminating the apparent alpha earned in good states (Figure 3). This was, in effect,
the AIG strategy. AIG is believed to have written around $1.0 trillion of CDS
protection. This strategy delivered large apparent "alpha" returns during the disco
years. But when the music ceased and true beta was revealed, AIG required state
support of around $180bn.
These five strategies are the latest incarnation of efforts by the banking system to boost
shareholder returns and, whether by accident or design, game the state. For the authorities,
it poses a dilemma. Ex-ante, they may well say "never again". But the ex-post costs of crisis
mean such a statement lacks credibility. Knowing this, the rational response by market
participants is to double their bets. This adds to the cost of future crises. And the larger these
costs, the lower the credibility of "never again" announcements. This is a doom loop.
The "St Petersburg paradox" explains how a gambling strategy which starts small but then
doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected
returns. Provided, that is, the gambler has the resources to double-up in the face of a losing
streak. The St Petersburg lottery has many similarities with the game played between the
state and the banks over the past century or so. The banks have repeatedly doubled-up. And
the state has underwritten any losing streak. Clearer practical examples of a policy
timeconsistency problem are unlikely to exist.
4. Resolving the time-inconsistency problem
In addressing this time-consistency problem, two broad approaches are possible: redesign of
the financial system to reduce the scale of insurable risks; and redesign of the social safety
net to make it less susceptible to gaming.
(a) Redesigning the financial system
What options best tackle excessive risk-taking incentives? A number suggest themselves,
some modest, others more radical.
•
Introducing leverage limits: One simple means of altering the rules of the
asymmetric game between banks and the state is to place heavier restrictions on
leverage. European banks were not subject to a regulatory leverage ratio in the
runup to crisis. They exploited that loophole. Closing it would bring about a clockwise
rotation in banks' payoff schedule, lowering the beta of banks' equity returns and
reducing risk-taking incentives.
This is an easy win. Simple leverage ratios already operate in countries such as the
US and Canada. They appear to have helped slow debt-fuelled balance sheet
inflation. The Basel Committee is now seeking to introduce leverage ratios
internationally. To be effective, it is important that leverage rules bite. They need to
be robust to the seductive, but ultimately siren, voices claiming this time is different.
That suggests they should operate as a regulatory rule (Pillar I), rather than being
left to supervisory discretion (Pillar II).
It is important, too, that leverage limits are set at the right level. Such limits need to
be fundamentally re-evaluated. We have sleepwalked into a world in which leverage
of 20 or 30 times capital is the rule rather than the exception. Now is a good time to
wake up. Evidence from the not-too-distant past suggests there may be less to fear
from materially higher capital ratios - say, a multiple of current ratios - than some
would suggest (Chart 2).
• Recalibrating risk weights: With hindsight, the capital assigned to certain categories
of high-risk and off balance sheet transactions by Basel rules was far too low. Those
mis-calibrations were then arbitraged by the banks in ways which included inflated
trading books and an over-expansion into high-risk loans and securitised assets.
The Basel Committee has already set about trying to correct some of the more
obvious of these defects. For example, materially higher risk weights are set to be
introduced for trading book assets from the end of 2010. This will include,
importantly, securitised and re-securitised products, whose payoffs profiles too
closely resembled deep out-of-the-money options (Figure 3). New risk weights
should better reflect the tail risk these products embody.
These reforms will close a regulatory loophole and thereby lower the beta of, and
hence systematic risk in, the banking system. They leave open some rather more
fundamental questions, which the Basel Committee are also considering. These
include whether the distinction between banking and trading books, and the
resecuritisation of assets, are necessary in the first place. If a robust financial and
regulatory system is one which is parsimonious and transparent, the answer might
be that they are not. It may be time to take Occam's razor to regulatory rulebooks.
•
Rethinking capital structure: Asymmetry of payoffs risks excessive risk-taking. The
source of this asymmetry is limited liability. It is revealing that limited liability was first
introduced into banking in the UK in the mid-19th century. That was roughly the time
state support for banks took shape. This is unlikely to have been serendipity. So
could the distortions from limited liability be tackled at source?
In the early days of banking, liability was not just unlimited; it was often as much
personal as financial. In 1360, a Barcelona banker was executed in front of his failed
bank, presumably as a way of discouraging generations of future bankers from
excessive risk-taking.16 It has not been conspicuously successful. From the Middle
Ages, debtor prisons replaced the gallows. They were a common feature of many
developed countries, including the US and UK, right up until the 19th century.
The switch to limited liability at that time was a conscious attempt to encourage risk
capital into the banking system to help finance growth. In essence, this meant
trading off financial risk against future productivity. At first, equity in banks often
carried "double liability", with shareholders liable for losses on the purchase price of
their shares plus their par value at issuance. Among state banks in the US during
the 19th and early 20th centuries, double liability is believed to have helped
constrain risk-taking.17
This practice was ended at the time of the Great Depression in the US. Given the
likely need to rebuild bank equity in the future, now may not be the time to return to
unlimited liability. Fortunately, there are two alternative approaches to adapting
capital structure which alter the balance of risk-taking incentives, without
jeopardising the flow of risk capital. Both involve operating not on equity, but on
debt. And both involve making debt, like equity, a more loss-absorbing instrument in
stress events.
First, contingent capital is a means of automatically converting debt instruments into
equity in the event of a capital top-up being needed. The capital structure of banks
thereby becomes more malleable. There has been recent interest in contingent
capital instruments as a means of providing banks with an extra degree of freedom
in stress situations.18 The benefits in principle seem clear. The difficulties in practice
include whether there is likely to be sufficient investor demand for such hybrid
instruments.
Second, wholesale debt instruments at present rank equally with retail deposits in
the UK in the event of a wind-up. In the US, depositor preference has operated
nationally since 1993, with retail deposits ranking ahead of wholesale debt. There
are benefits to depositor preference both ex-ante (by heightening debtor incentives
to monitor risk) and ex-post (by facilitating resolution). There are also some potential
downsides, including causing unsecured creditors to run sooner. It may be a good
time to reweigh these arguments in the UK.
•
Reconsidering the industrial organisation of banking: Over the past few decades, the
global banking system has evolved into a particular organisational form, with a small
number of large banks, a high degree of concentration and relatively low rates of
entry and exit. Events of the past two years have accelerated these trends. In 1998,
the five largest global banks had around 8% of global banking assets. By 2008, this
fraction had doubled to around 16% (Chart 10).
These structural trends worsen the time-consistency problem for the authorities,
increasing the pressure for state support to banks "too important to fail". This has
heightened recent interest in rethinking the industrial organisation of finance.19
There are a number of potential forms such a restructuring could take.20 In weighing
these options, there may be lessons from an, on the face of it, unlikely corner of
finance: hedge funds.
Hedge funds started this crisis in the doghouse. Yet they are the dog that has not
barked. Their industrial structure may explain why. Unlike banking, the hedge fund
sector does not comprise a small number of large players, but rather a large number
of relatively small players. The largest hedge funds typically have assets under
management of less than $40bn, the largest banks assets in excess of $3 trillion.
Unlike banking, concentration in the hedge fund sector is low and has been falling.
The top 5 hedge funds comprise around 8% of total assets, down from 30% a
decade ago (Chart 10). Unlike banking, the business models of hedge funds are
typically specialised rather than diversified. And unlike banking, entry and exit rates
from the hedge fund industry are both high. The annual average attrition rate for
hedge funds is around 5%. At present, it is around double that. Among US banks,
the average attrition rate over the past few decades has been less than 0.1%; it has
not come close to hitting 5% at any point since the Great Depression.
It may be coincidence that the structure of the hedge fund sector emerged in the
absence of state regulation and state support. It may be coincidence that the
majority of hedge funds operate as partnerships with unlimited liability. It may be
coincidence that, despite their moniker of "highly-leveraged institutions", most hedge
funds today operate with leverage less than a tenth that of the largest global banks.
Or perhaps it might be that the structure of this sector delivered greater systemic
robustness than could be achieved through prudential regulation. If so, that is an
important lesson for other parts of the financial system.
(b) Redesigning the safety net
•
A framework for the banking safety net: Even with systemic risk reduced, the state is
unlikely to be able credibly to stand aside when future tail risks eventuate, as they
are sure to do. Some bulwark is needed. As in other public policy arena, a
predefined and transparent regime can help reinforce the credibility of ex-post actions,
serving as a pre-commitment device.
At present, only some of the ingredients of such an ex-ante framework exist.
Internationally, deposit insurance frameworks tend to be fairly well-defined; liquidity
insurance frameworks somewhat less so. Both are much better defined than
frameworks for capital insurance. A well-articulated framework for the banking safety
net would not only provide greater clarity on each of these pieces. It would also set
out interactions and interdependencies between them - when and how the different
insurance strands come together to avert crisis. At present, no such ex-ante map
exists. Having one in future would not guarantee, but could only increase, the
chances of it being adhered to.
•
Time-consistent