Financial sector guarantees are a key public policy tool
All financial claims are risky. Against this background, governments have traditionally provided support for guarantees of financial claims, provided they of public policy interest. This choice is based on the view that adequately priced financial transactions enhance welfare. Ideally, such transactions allow risk to be allocated to those most capable of bearing it. By conveying reassurance, guarantees encourage risk-taking and activity that otherwise wouldn’t occur.
Governments provide guarantees in various ways. They directly provide guarantees for claims among private entities. They also encourage private financial intermediaries to provide guarantees. And they also make available subsidies, favorable regulatory treatment or public back-stops. There are many examples of financial sector guarantees, including retail deposit insurance, pension benefit guarantees, and guarantees for bank loans to small and medium-sized businesses.
Costs and benefits need to be better understood
International organisations intensify their work on financial sector guarantees since the 2008 global financial crisis. Most policy responses for achieving and maintaining financial stability consisted of providing new or extended guarantees for the liabilities and assets of financial institutions. But even before this, guarantees were already an instrument of first choice to address a number of financial policy objectives. Such objectives are various. They include protecting consumers and investors and achieving more desirable credit allocations.
Alternatives to guarantees exist. For example, to achieve more desirable credit allocations, public entities also lend directly. In Europe, for example, direct public lending in less well developed financial market segments has been shown to achieve additional growth of beneficiary firms as compared to similar peers. Nonetheless, the incidence and scope of various types of financial sector guarantees is increasing steadily. To explain, this type of public intervention is easier to justify given tight fiscal constraints and it conceptually leaves room for private initiatives.
Guarantees are a preferred policy instrument. Thus, a number of OECD reports analyse financial sector guarantees in light of ongoing market developments and discussions within the OECD Committee on Financial Markets. They show how the perception of the costs and benefits of financial sector guarantees evolve in reaction to economic and financial market developments. This includes in particular the outlook for financial stability and real activity. Regardless of the specific context, a key conclusion is that financial sector guarantees need to be adequately priced. This way they can achieve their desired effects in terms of financial stability and economic efficiency. By contrast, underpriced guarantees create distortions to incentives.
Some guarantees remain underpriced
Unfortunately, some guarantees are not adequately priced. For example, access to the financial safety net is not adequately priced, giving rise to implicit guarantees. These are by definition not charged for, at least not explicitly. They are costly and distort capital allocation. This situation is evident from long-term growth trends. “Financial excesses” – situations where bank credit reaches levels that reduce real economic growth – have been stronger in OECD countries characterised by larger values of implicit bank debt. As a result, the banking sector has grown to levels not conducive to real activity growth. Implicit bank debt guarantees benefit financial sector employees and other high-income earners, increasing income inequality. Thus, policy makers attempt to rein in the values of such guarantees not only to make the financial system more efficient and stable but also fairer.
An evaluation by the Financial Stability Board of the effects of too-big-to-fail (TBTF) reforms identifies progress in this regard and remaining gaps. The estimated value of implicit guarantees has declined from its peak. It is however higher than before the 2008 crisis. The evaluation concludes that more can be done to fully realise the benefits of these reforms.
