Financial crises lead to policy interventions that carry significant fiscal costs (Laeven and Valencia, 2013). While policy makers prefer to follow the prescription in Bagehot (1873) that public funds should only be provided to institutions that are expected to repay them, it is difficult to determine ex ante an institution’s ability to repay. The resulting tension has been highlighted by the debate on whether the collapse of Lehman Brothers—an inflection point of the 2007–09 global financial crisis—should have been prevented.[1] Recent financial regulation reform alleviates this tension by formulating an amended version of Bagehot’s prescription. It requires that public funds that cannot be recovered from individual institutions should be recovered by imposing levies on the broader financial sector.[2] However, levies that are imposed to recoup bailout funds may distort financial sector actions—with various potential repercussions throughout the economy. As a result, it is not obvious who are the net beneficiaries, and net payers, of a financial-sector funded bailout.
This blog post discusses the distributional consequences of financial sector-funded bailouts. Because such an analysis requires the comparison of counterfactuals—i.e., what happens with bailouts and what would have happened without them—a structural model is necessary.[3] At the heart of the structural analysis in this post is that the financial sector (“banks”) intermediates between businesses and households. On the one hand, businesses require bank loans to fund investment. On the other hand, households experience stochastic idiosyncratic shocks to their income from labor and business ownership and use bank loans and bank debt to smooth consumption over time. Poor households use bank loans to fund current consumption while wealthy households hold bank debt to fund future consumption.
My model assumes that banks must back a fraction of their lending with equity, and this “skin in the game” reassures bank creditors that banks are making loans of sufficient quality to avoid bank defaults. In practice, banks also face regulatory (equity) capital constraints, but it is the bank funding market that reacts most strongly to changes in a bank’s equity.
During a financial crisis, when bank equity is declining, banks cannot absorb all household savings and must reduce loans to businesses. When banks’ balance sheets become a bottleneck during financial crises in this way, the interest rate on savings drops and the interest rate on bank loans spikes. Households are hurt during financial crises because of lower savings rates and lower wages (businesses have lower demand for labor if pricier loans force them to reduce investment).
I use the model economy to study the implications of a policy that injects equity into banks—to increase their access to funding and thus their loan supply—and recoups the initial injection by taxing banks over time. This type of policy reduces the cost of bank loans during a financial crisis at the cost of raising it somewhat in future periods as banks pass on the tax to borrowers. The equity injection prevents a disruption of bank intermediation activity and thus avoids a scarcity of both bank loans and bank debt. As a result, wages and the return on savings are stabilized in the short-run, which benefits both poor and wealthy households. In the long-run, however, wages are depressed because the tax on lending increases the funding cost of businesses which decreases their demand for labor. Figure 1 illustrates that the bailout stabilizes financial variables – the interest rate on bonds issued by banks and the interest rate on bank loans – much more than economic activity, which remains significantly depressed in the long term.
Figure 1
Our main finding is that equity injections that are funded by a tax on bank lending redistribute from poor to wealthy households in the economy, even though average welfare increases. This is because the cost of the equity injection is long-term and disproportionately affects poor households because they rely primarily on labor income. On net, wealthy households benefit greatly from a stabilized return on savings while poor households are somewhat worse off. Figure 2 illustrates that households with net worth below $27,000 do not benefit from the bailout while wealthier households can be significantly better off.[4] For example, a household with net worth of $200,000 values the net benefit of the bailout as equivalent to 0.2 percent of what the household consumes over its entire lifetime.
Figure 2
Bailouts not only increase loan supply to businesses but also increase the supply of safe assets to savers. In a world of high wealth inequality, and correspondingly high demand for safe assets to carry forward large amounts of wealth over time, the second effect is important. During a financial crisis without bailouts, banks recapitalize over time by charging borrowers more (higher interest rate on bank loans) and by paying their creditors less (lower interest rate on bank debt). However, a bailout recapitalizes banks by only charging borrowers more, through the long-term tax on bank lending, while leaving bank creditors unharmed. Equity injections therefore shift the burden of recovery onto households with low financial assets, even though the average social cost of financial crises is reduced. The finding that a common policy response to financial crises, i.e., equity injections, does not deliver broad welfare gains and instead exacerbates inequality has the policy implication that financial institutions should hold more equity ex ante.
The analysis contributes to the evaluation of recent reforms of financial crisis resolution aimed at ending “too big too fail” (Dodd-Frank, 2010; BRRD, 2014). It also speaks to ad-hoc policy interventions that ultimately passed on the cost of alleviating financial crises to financial institutions. For example, the U.S. Federal Deposit Insurance Corporation required bridge funding during the Savings and Loan Crisis, but eventually repaid the bridge funding by raising deposit insurance premiums from banks. Similar, during the 2007–2009 financial crisis, the Troubled Asset Relief Program provided funds to financial institutions and subsequently recovered those funds. That regulators let the financial sector pay for bailouts is arguably an improvement in regulatory conduct; however, additional fiscal measures may be required to correct adverse distributional implications.
In conclusion, bailouts improve economic activity modestly but immediately. They increase wages and the return on savings, and decrease borrowing costs. However, the tax associated with repaying a bailout distorts the future borrowing costs of businesses upward which reduces future wages. Thus, while the short-term gains of bailouts are widely shared, the long-term costs accrue to households that rely primarily on labor income. Financial sector bailouts therefore, on net, redistribute from poor to wealthy households and this finding holds even though welfare increases on average. The failure of bailouts to deliver welfare gains broadly ex post has the policy implication that financial institutions should hold more equity ex ante.
[1] Indicative of the controversy (e.g. New York Times, 2014), Ben Bernanke, chairman of the Federal Reserve at the time, vehemently defended the decision not to bail out Lehman: “I will maintain to my deathbed that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority.”
[2] Letting the financial sector, rather than taxpayers, pay for any losses from resolving a financial crisis is one ‘key attribute of effective resolution’ formulated by the Financial Stability Board and agreed by the G20 in the aftermath of the global financial crisis. Prominent examples of implementations are the Orderly Liquidation Authority of the Dodd-Frank Act in the United States and the Single Resolution Fund of the Bank Recovery and Resolution Directive in the European Union (Dodd-Frank, 2010; BRRD, 2014).
[3] I base this post on the model in Schroth (2020).
[4] The distribution of household net worth is calibrated using the 2010 Survey of Consumer Finances; households with net worth below $27,000 are about 40 percent of the population under this calibration.
References
Bagehot, Walter. Lombard street. King, 1873.
BRRD (2014). Bank Recovery and Resolution Directive 59/EU. Official Journal of the European Union.
Dodd-Frank (2010). Dodd-Frank Wall Street Reform and Consumer Protection Act. Public Law 111-203 [HR 4173]. GPO Washington, DC.
Laeven, Luc, and Fabian Valencia. “Systemic banking crises database.” IMF Economic Review 61.2 (2013): 225-270.
New York Times (2014). Lehman Revisited: The Bailout That Never Was. The New York Times. September 30th, page A1.
Schroth (2020). On the Distributional Effects of Bank Bailouts. Forthcoming Review of Economic Dynamics
Josef Schroth is a Principal Researcher in the Financial Stability Department at the Bank of Canada.
Any expressed views do not represent the views or opinions of the Bank of Canada.
