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.
Bank of International Settlements Working Paper no. 599
September 25, 2009