Global Financial Stability Report
31 March 2014
International Monetary Fund
How big is the implicit subsidy for banks considered too important to fail?
Chapter 3 looks at the issue of too-important-to-fail and provides new estimates of the implicit funding subsidy received by systemically important banks. The subsidy comes from the expectation that the government will support large banks if they get into distress. Although financial reforms have helped reduce this subsidy, it remains sizeable. Policymakers should aim to remove this advantage to protect taxpayers, ensure a level playing field, and promote financial stability.
Government protection for too-important-to-fail (TITF) banks creates a variety of problems: an uneven playing field, excessive risk-taking, and large costs for the public sector. Because creditors of systemically important banks (SIBs) do not bear the full cost of failure, they are willing to provide funding without paying sufficient attention to the banks’ risk profiles, thereby encouraging leverage and risk-taking. SIBs thus enjoy a competitive advantage over banks of lesser systemic importance and may engage in riskier activities, increasing systemic risk. Required fiscal outlays to bail out SIBs in the event of distress are often substantial.
The TITF problem has likely intensified in the wake of the financial crisis. When the crisis started in 2007, and especially in the wake of the financial turmoil that followed the collapse of Lehman Brothers in September 2008, governments intervened with large amounts of funds to support distressed banks and safeguard financial stability, leaving little uncertainty about their willingness to bail out failing SIBs. These developments reinforced incentives for banks to grow larger and, together with occasional government support for bank mergers, the banking sector in many countries has, indeed, become more concentrated.
In response, policymakers have launched ambitious financial reforms. They imposed higher capital buffers and strengthened the supervision of global systemically important banks (G-SIBs) to reduce the probability and cost of failure and contagion. They are working on improving domestic and cross-border resolution frameworks for large and complex financial institutions. In some countries, policymakers decided on structural measures to limit certain bank activities.
This chapter assesses how likely these policy efforts are to alleviate the TITF issue by investigating the evolution of funding cost advantages enjoyed by SIBs. The expectation of government support in case of distress represents an implicit public subsidy to those banks.
Subsidies rose across the board during the crisis but have since declined in most countries, as banks repair their balance sheets and financial reforms are put forward. Estimated subsidies remain more elevated in the euro area than in the United States, likely reflecting the different speed of balance sheet repair, as well as differences in the policy response to the problems in the banking sector. All in all, however, the expected probability that SIBs will be bailed out remains high in all regions.
Not all policy measures have been completed or implemented, and there is still scope for further strengthening of reforms. These reforms include enhancing capital requirements for SIBs or imposing a financial stability contribution based on the size of a bank’s liabilities. Progress is also needed in facilitating the supervision and resolution of cross-border financial institutions. In these areas, international coordination is critical to avoid new distortions and negative cross-country spillovers, which may have increased due to country-specific policy reforms.