Ten years after the crisis, financial regulation leaves taxpayers holding the bag for banks’ safety net.
Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time. In this game, regulatees tend to make more moves in pursuit of safety-net subsidies than regulators can or do make to stop them. Moreover, regulatee moves tend to be faster and more creative, and to have less-transparent consequences than the moves that regulators make.
In modern times, banking crises have occurred when managers pursued concentrated risks that made their institutions increasingly vulnerable, but generated a series of substantial and long-lasting safety-net subsidies until things finally went south. As I explore in my new INET working paper, such subsidies can prove long-lasting because the regulatory cultures of almost every country in the world today embrace—in one form or another—three strategic elements:
- Politically-Directed Subsidies to Selected Borrowers: The policy framework either explicitly requires—or implicitly rewards—institutions for making credit available to favored classes of borrowers at a subsidized interest rate. In recent crises, subsidized loans to homeowners played this role. However, the next crisis may feature loans to current and former students, pension funds, and state and local entities;
- Subsidies to Bank Risk-Taking: The policy framework commits government officials to offer on subsidized terms explicit and/or implicit (i.e., conjectural) guarantees of repayment to banks’ depositors and other kinds of counterparties engaging in complex forms of bank deal making;
- Defective Monitoring and Control of the Subsidies: The contracting and accounting frameworks used by banks and government officials leave no paper trail. They are careful not to make anyone directly accountable for reporting or controlling the size of these subsidies in a conscientious or timely fashion.
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