Banks, industry policy and too big to fail

The recent economic problems in the US and Europe have re-opened discussion of the role of banks within our economy, and particularly on the issue of whether they enjoy implicit government support. The shorthand for the issue is usually expressed in asking whether banks are too big to fail.

The current debate lacks any sensible context. Normally public discussion of government support for industry is couched in terms of industry policy and that seems the natural framework for discussion (implicit) support for banks.

The Govertnment supports a wide range of industries through a system of explicit subsidies. We all know the cases of the automotive industry in Australia, and the case of protection for textile, clothing and footwear, but there is a wide range of industries which receive explicit support including the film industry, Tasmanian forestry and many others. Much of the support is explainable through interest group theory.

Identifying the areas of implicit government support is more difficult. In the US during the crisis, the automotive industry received significant government aupport, so did the insurance industry, and the securitisation industry, not just banking – much implicit support became explicit. The US government decided that firms in all those industries were too big, too important, too powerful or too interconnected to fail..

In a smaller economy like Australia, with a more concentrated commercial sector, it is quite possible that there are many more firms government would prevent from failing, and which are effectively enjoying implicit government subsidies.

It is hard to believe for example that Telstra would be allowed to fail, nor apparently could the ASX fail, and one wonders about AustralianSuper, AMP, AGL, Queensland Rail and many others. All these firms are probably enjoying implicit government subsidies. We have even seen government intervention to support aluminium smelters, as well as intervening to prop up the securitisation market to assist small financial institutions to stay in business. Size is clearly not the only relevant criterion.

In some cases, as with banks, the government imposes onerous regulation to offset some of its risk, but it does not do this on any consistent basis.

So what are the boundaries around the concept of implicit government support? This is at heart a deep question of public policy, which requires a structured framework for analysis, and not simply the ad hoc approach we currently pursue. The too-big-to-fail metric might provide one dimension of analysis but recent government behaviour has taught us that there are many more, and size alone may not be the most relevant as we have seen in the support of many small institutons.

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  1. Rod, too big to fail in banking is probably shorthand for concerns that stem from contagion risk. In the case of banks contagion risk arises from a loss of confidence on the part of depositors, and a run on the bank may ensue, and like dominoes other institutions come under pressure. It’s not clear to me that too big to fail in the car industry, or telecommunications, or electricity industries has the same conceptual underpinnings. In these cases other considerations may apply. The car industry supports jobs, often in areas of disadvantage… So there is a political imperative to save vulnerable jobs…

    So I guess there needs to be careful attention to the underlying policy rationale ….it seems that this will be stronger for some industries than for others. In my book, the car industry is too big to succeed… In other words, it draws too many public resources to prop up an inefficient sector.

    • I am not sure I agree that the concept of contagion is specific to banking.. Clearly governmental concern both here and in the US about the automobile industry was based on contagion, the old fashioned concept of backward and forward linkages. Government intervention here in the securitization industry cannot be explained by contagion – we need a richer conceptual framework.

      • Rod, I believe that there is a difference between interdependence, that arises through economic linkages, and contagion which refers to a vulnerability that arises from reactions to extreme negative events that can flow through and across economies. Different policy responses follow from differentiation of the Issues.
        Mitigating contagion is more likely to focus on policies or regulations that instil confidence or which address informational asymmetries. Whereas we will generally seek to avoid the extreme consequences of contagion, we may be less concerned by the up and downstream consequences of decline (or growth) of an industry….particularly if the latter is accepted as structural change.

        I accept that these distinctions tend to get lost in the middle of a crisis. However, my point is that the term contagion appears to be used opportunistically to invoke intervention when cooler heads should have prevailed.

  2. I think it’s a little ironic how your lists are essentially government created entities that have been privatised over the past few decades, only to receive implicit government guarantees of their business. Maybe governments do have a legitimate role in owning these crucial industries? Obviously things aren’t black and white, but privatising monopolies and then guaranteeing them against their own stupidity seems a little naive I would say.

  3. The key issue is moral hazard, so the limits to government support exist in the eyes of the risk-takers. With banking in particular, recent history has shown us how difficult it is to deal with moral hazard that can be created by government support.
    Fractional reserve banking naturally requires depositor confidence, otherwise perfectly healthy banks go under. Over many years our regulators steadily gained depositors’ confidence with a stable banking environment, but it also spread an implicit understanding that the government would step in if required. This was despite the regulator stressing there was no guarantee. Expectations were of course fulfilled when the government did step in during the GFC, and this now explicit guarantee is retained (for retail depositors).
    For retail depositors there is probably no convincing anyone otherwise. But it might be possible for larger ‘depositors’. The US proposals for TBTF banks include requiring these important institutions to submit “living wills”, which detail exactly how the institution can be wound up without government support. To the extent markets believe such wind-ups are possible, the moral hazard can be ameliorated.
    So could we convince people that Telstra or Queensland Rail could be wound up without government support? For me, the answer to that tells us whether implicit support exists.