The 'Shadow Financial System' of Government Guarantees

Includes: AIG, BAC, C, GS, JPM, RBS, WFC, XLF
by: Michael Pomerleano

We are witnessing the widespread use of guarantees, which suggests that policymakers consider them a “free lunch” permitting them to bypass budgetary scrutiny. I advocate that guarantees should be transparent, judicious and temporary and applied only in specific circumstances.

Previous financial crises have seen the use of government blanket guarantees, which are blunt instruments. Such measures for depositors and creditors were introduced in East Asia to protect banking system stability.

While the guarantees brought stability, they limited the subsequent options for dealing with financial distress. The guarantees created complacency equivalent to injecting a patient with an anaesthetic; it takes away the pain but it does not address the underlying problem. The guarantees only delay the restructuring, while increasing the costs. The lessons from the Asian crisis suggest that blanket guarantees can have adverse consequences for financial system stability. Guarantees delay economic recovery and increase the fiscal costs of crises.

Are we are about to repeat these mistakes? Yes. Ironically, the guarantees have been used excessively in the US and other countries as a substitute for on-balance-sheet government funding by policymakers who criticised the “shadow banking system.”

Policymakers have created a “shadow budget system”, with guarantees that Congress does not scrutinise. The extensive use of guarantees is only coming to light in the case of AIG, the bailed-out insurance group. The “stealth” use of government blanket guarantees in the recent crisis requires scrutiny.

According to Bloomberg News, the commitments are large and potentially very costly. In the US alone, government guarantees account for 79 per cent of gross domestic product. The US government, Bloomberg data show, has provided more than $11.6 trillion to date in guarantees on behalf of American taxpayers.

Were these guarantees priced to instil market discipline? This is unlikely. The evidence points to ad hoc “weekend” improvisation in the cases of Bear Stearns, Citi and AIG. Assets were covered with blanket guarantees without adequate consideration for the guarantees’ ultimate costs.

What will be the ultimate fiscal cost of this commitment? We do not know, but we can offer an indicative range; upward of $1.5 trillion. In Thailand, where the guarantees covered the liabilities of the banking system, Idanna Kaplan-Appio, (”Estimating the Value of Implicit Government Guarantees to Thai Banks.” Review of International Economics 10 (1): 26-35, 2002) estimated the value of the government guarantee, using put options, at 15 per cent of the banking system’s liabilities. Governments cannot hedge to offset the risk(s) they take on via this (implicit) put.

So the “potential costs of the guarantees” could be much greater than the 15 per cent estimate provided. While the institutional foundations of the US financial system are stronger, the severity of the crisis and complexity of the instruments suggest that 15 per cent cost is a lower bound. The US has committed to $1.76 trillion governmental expenditure without any congressional budgetary scrutiny.

Examples of the guarantees abound. The Royal Bank of Scotland’s (NYSE:RBS) Overview on Guarantee Schemes, third edition, dated 30 January 2009, provides an informed overview of bank debt guarantee schemes around the globe. Numerous countries have established guarantee schemes recently: Germany (NORD/LB), South Korea, the UK, France (Dexia), Canada, Spain Australia, Austria, Denmark, Finland, Greece, Ireland, Italy, the Netherlands, New Zealand, Portugal, and Sweden.

What are the risks? The government guarantee schemes have considerable risks. Yet they have hardly received scrutiny by policy analysts and academics. An exception is a recent article by Ed Kane, “Safety-net Subsidies Keep ‘Toxic’ Assets Illiquid”. Ed points out that guarantees encourage “zombie” institutions to hang on to worthless toxic assets on the remote chance that the market for toxic assets will recover.

What are the findings in the academic literature? The theoretical literature is unequivocal on the moral hazard associated with blanket guarantees. It points out that governments limit their policy options by implementing blanket guarantees that extend forbearance.

Moreover, the fiscal costs of a crisis are not predetermined. If the underlying problems get swept under the rug, the “silent” crisis lingers and the costs escalate. In the absence of a resolution, the recovery is delayed. In my empirical research on the topic I found that the blanket guarantees variable is robust to any specification, including controlling for the depth of the crisis.

Blanket guarantees increase fiscal costs, while lengthening the duration of the crisis and the GDP loss. The academic literature favours a stricter response to crisis resolution. It finds that accommodative policies, reflected in blanket guarantees and other forms of forbearance, add to the fiscal cost of banking crises but do not accelerate the recovery speed. Much of the variation in fiscal costs is explained by poor policy measures, such as forbearance and muddling through with half measures.

The puzzle of why governments continue to use blanket guarantees in crisis after crisis, despite the universal understanding that they entail high contingent costs and create moral hazard problems, is easy to explain. Governments use blanket guarantees to stabilise sizable systemic financial crises in the absence of the institutional and political will or the fiscal headroom needed to address the problems head-on.

The academic literature offers robust statistical evidence that blanket guarantees increase fiscal costs, prolong the duration of a crisis, and increase the GDP loss. Policymakers are advised to adopt a programme that deals with the underlying problems and use blanket government guarantees sparingly. The US Congress is advised to hold the administration accountable for the use of guarantees by ensuring that they are priced properly and their costs are disclosed explicitly.

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