Banking on the State

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. 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 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. 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.
So what can be done? There are many reform proposals on the table. 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.

Andrew G. Haldane

Bank of International Settlements Working Paper no. 599

September 25, 2009

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