Why we GIVE each big bank $12 billion per year

I've been reading quite a lot about the various political battles over efforts to regulate the banking industry, derivatives in particular. This afternoon, quite by coincidence, I noticed on a colleagues' disordered desk a copy of a speech given last year by Andrew Haldane, Executive Director for Financial Stability of the Bank of England. It's message should be a matter of urgent public debate in the US, and elsewhere. Yet I haven't heard Haldane's arguments mentioned anywhere in the US media.

Banks, he argues, are polluters, and they need to be controlled as such. Let me run through several points in a little more detail. First think of the car industry, where producers and users together pollute. Haldane:

"Exhaust fumes are a noxious by-product. Motoring benefits those producing and consuming car travel services – the private benefits of motoring. But it also endangers innocent bystanders within the wider community – the social costs of exhaust pollution."

He then goes on to make the point that we now face much the same situation with bankers, in part due to the proliferation of instruments which have made it possible for banks to spread risks far and wide and make profits events as they amplify system wide risks. The banking industry is also a polluter:

"Systemic risk is a noxious by-product. Banking benefits those producing and consuming financial services – the private benefits for bank employees, depositors, borrowers and investors. But it also risks endangering innocent bystanders within the wider economy – the social costs to the general public from banking crises."

What is to be done about polluters? Back in the 1970s, in the face of the rising air pollution, policy makers, guided by economists, worked out ways to solve the problem through regulations and, where necessary, outright prohibitions of some practices. That's where we are now with the banks. The regulations under consideration recognize the social costs of systemic risk and try sensibly to find a redress. The bankers response has of course been to whine and scream.

The first practical step in addressing a pollution problem is to estimate how much pollution there is. How much do we pay to guarantee bank solvency during these not-too-infrequent systemic crises? Haldane points out that if you count only the monetary amount transferred to banks by governments, the cost of the recent crisis is fairly large -- about $100 billion in the US. But this is probably an extreme lower bound to the true collective cost. As Haldane remarks,

"...these direct fiscal costs are almost certainly an underestimate of the damage to the wider economy which has resulted from the crisis – the true social costs of crisis. World output in 2009 is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis. In the UK, the equivalent output loss is around 10%. In money terms, that translates into output losses of $4 trillion [for the US] and £140 billion [for the UK] respectively."

Now, I'm not one to take GDP loss arguments too seriously. It's not a very good measure of human well being, or even of the narrow economic well being of a nation (in particular, it tells us nothing at all about how much of the store of natural resources may have been eaten up in achieving that GDP). However, the scale alone in this case suggests that the cost of the crisis -- and other crises, which seem to strike more and more frequently with modern financial engineering and its global reach -- are immensely high.

But here is where Haldane's view becomes REALLY interesting -- and goes beyond anything you're likely to see in the popular media (especially in the US).

Lots of people recklessly borrowed in the run up to the crisis; it wasn't only the fault of the recklessly loaning banks. So, how much of the systemic costs associated with financial crises really is due to the banks? One place to look, Haldane suggests, is the valuations given to banks by the ratings agencies, many of which take explicit note of the fact that governments give a subsidy to banks in the form of implicit or explicit safegaurds to their stability. Some give banks two different ratings, one "with government support" and one "without." Haldane goes through a simple calculation based on these ratings, and estimates the effective subsidy to many big banks is on the scale of billions. The data suggests it has been increasing for the past 50 years. The "too big to fail" problem shows up in the data as well -- the average ratings difference for large banks is much bigger than it is for small banks. As Haldane sums up:

For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year...  the large banks account for over 90% of the total implied subsidy. On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a real and on-going windfall for the banks."

Haldane's speech -- as far as I'm aware -- is unique among high-level banking figures in taking seriously the public costs entailed by banking practices. Imagine where the US might be today if we'd taken that $60 billion per year and, over the past decade, invested it in infastructure, education and scientific research.

In the rest of his speech, Haldane explores what might be done to end or control this pollution, through taxes or by making some banking practices illegal. This too is illuminating, although what emerges is the view that finding a solution itself isn't so hard. What is hard is gathering the political will to take steps in the face of banking opposition. Publicizing how much they pollute, and how much we pay to let them do it, is perhaps a first step.