Editorial Board

Why You Should Care About That $83 Billion Bank Subsidy

Our estimate that taxpayers provide an $83 billion annual subsidy to the largest U.S. banks has provoked a lot of debate. Amid the arguments over methodology, the most important points may be getting lost. So here they are: The subsidy is too large, it is bad for the economy, and the best way to deal with it is through measures such as increased capital requirements.

The subsidy comes in the form of lower borrowing costs, which large banks enjoy because creditors expect the government to bail them out in an emergency. We assumed, in consultation with a co-author of an International Monetary Fund working paper on the subject, that the funding advantage amounts to 0.8 percentage point over the longer term, and that applying the number to banks’ total liabilities is the best way to get at its dollar value.

Reasonable people can make different assumptions and arrive at different answers. The economists Frederic Schweikhard and Zoe Tsesmelidakis estimated the subsidy was about $32 billion a year for the bond debt of U.S. banks alone, from 2007 through 2010. Andy Haldane, a senior official at the Bank of England, put the subsidy at $60 billion a year for the five largest global banks, from 2007 through 2009. A. Joseph Warburton and Deniz Anginer, respectively of Syracuse University and Virginia Tech, found that the subsidy for the largest U.S. banks went from less than $10 billion in 2004 to more than $100 billion in 2009. Ed Kane of Boston College put it at $300 billion for 2009 alone.

Exact Size

The subsidy’s exact size is less important than its effects. By providing an extra measure of insurance to banks that have the potential to tank the economy, the government encourages them to become as threatening as possible. In other words, the desire to mitigate crises undermines the market discipline that would otherwise keep banks from getting so big.

The repercussions of taxpayer support for banks are far-reaching. To steal a thought from a previous editorial, if you subsidize corn farmers, you get too much corn. If you subsidize banks, you get too much credit. As of September, the total debts of households, companies and governments in the U.S. stood at 2.5 times annual economic output, up from 1.3 times in 1980. While it’s hard to say what the right level should be, the recent credit-related crises in the U.S. and Europe suggest we’re pushing the outer limits.

What can be done about the subsidy? Some efforts to quantify it have been aimed at designing a tax that would extract reimbursement from the banks. This would probably be too blunt an instrument. It would punish some institutions too harshly, because the size of the subsidy can differ for individual banks, depending on how much they rely on government support.

A better approach would be to make banks less likely to need taxpayer bailouts. Doing so would automatically reduce the subsidy precisely in proportion to its size for any given bank. The cost to well-run banks would be lower than the cost to banks taking big risks at taxpayers’ expense.

The most effective subsidy-reducing tool is capital -- that is, the equity shareholders put into the enterprise, as opposed to the money banks borrow to augment their investments. Equity absorbs losses, making banks less likely to require taxpayer support in an emergency.

Research from the Bank of England suggests that if banks had $1 of shareholder equity for each $5 in assets, the benefits would outweigh the costs. Current global rules require just $1 in equity for each $33 in assets. In their new book, “The Bankers’ New Clothes,” economists Anat Admati and Martin Hellwig explain in detail how higher levels of equity would benefit the financial system and the economy.

Subsidy Curb

Another subsidy curb, already used in Ireland and Spain, is to require some creditors to take losses when banks get into trouble. Investors would then demand a higher yield to compensate for the added risk of lending to big banks, removing some of the funding advantage. Also, the pending Volcker rule in the U.S. and financial ring-fencing measures in the U.K. pare down the subsidy by preventing large universal banks from using it to finance speculative trading.

We’ve established that the largest global banks receive a big taxpayer subsidy. Even Federal Reserve Chairman Ben S. Bernanke agrees, judging from his statements to the Senate this week. Let’s move on to the question of what to do about it.

(For more on this subject, see our original editorial and our initial and further responses to critics.)