Bank bailout guarantees and public debt

Angelo Baglioni, Umberto Cherubini

01 December 2010

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The turmoil currently taking place in Ireland is the direct consequence of the troubles affecting its banking system and the bailout guarantee provided by the Irish government. Some had predicted the challenges this would pose (see Kelly 2010 and Honohan and Lane 2009). European governments have committed a lot of money to the rescue of their banks. But even more importantly, governments are providing an implicit guarantee to the banking sector, possibly going beyond the amounts that have thus far been explicitly committed.

The expectation of bailouts can be seen clearly from quotes on credit default swap markets. The default risk priced by the market shows a remarkable co-movement between the financial and the public sectors, confirming that governments are expected to take up the losses possibly incurred by banks.

Now, the question is:

  • If the implicit guarantee provided by a government to the financial system were marked-to-market, what would be the impact on public debt figures?

In other words:

  • How much should each government pay in order to buy an insurance against the default of one financial institution, or even of the whole financial system of the country? 

This issue is becoming increasingly important in the policy debate on the reform of the Stability Pact in Europe, where some policymakers argue that private debt should be included in the evaluation of the financial soundness of member countries. This view is quite reasonable as long as the liabilities of financial intermediaries are concerned, since they can affect the public sector through the above mentioned guarantee. It is less reasonable as far as the liabilities of other private sectors – like households and firms – are concerned, since their impact on public finance is much less evident.

The government liabilities implicit in the bailout guarantees amount to a significant share of GDP in several countries (see Table 1). It is huge for Ireland, lower but still important for Greece, Italy, Portugal, and Spain and for the UK. The two crucial factors determining these figures are:

  • the size of the banking system relative to the economy of each country (Ireland and the UK have the largest);
  • the correlation among the default probabilities of banks within a country, which determines the likelihood of a systemic crisis (this correlation is lowest in Germany);.

Table 1. Bailout government liability and debt/GDP

 

The numbers shown in the second column of Table 1 are obtained by multiplying the probability of a systemic shock (affecting the whole banking sector of a country) by the loss incurred in such a case. This product measures the expected loss incurred by the government due to the implicit insurance it provides to the banking system and it is the fair premium it should pay to buy a re-insurance coverage in financial markets. The probability of a systemic event, in turn, is computed by exploiting the information provided by the time series of the five year credit default swaps spreads of the major banks in each European country. The loss given default is set equal to 60% of bank total assets, following the convention used in the credit default swap market (see details in Baglioni and Cherubini 2010).

The estimated market values of the bailout guarantees needed to avoid a systemic crisis in the banking sector are associated to the amounts actually committed to serve such a purpose by the 10 European governments considered here. The total amounts are very similar, namely €2,245 billion (implicit liabilities) against €2,330 billion (commitments)1. The degree of association is clear from Figure 1. However, the difference between government liabilities and commitments shows quite a large degree of variation across countries. The two extreme cases are Germany, for which the commitments are largely higher than the liability, and this can be attributed to the low systemic content of bank default probabilities; and Italy, which reports the lowest level of commitments along with Portugal, in spite of a larger banking system. A surprise is Ireland. This is the country whihc, after Germany, has the highest positive difference between the value of commitments and that of the expected liability. However, the actual burden that the public sector is carrying for banks is not sustainable, making financial assistance by international institutions unavoidable.

Figure 1. Government implicit liabilities and actual commitments (€ billions)

References

Baglioni and Cherubini (2010), “Marking-to-market Government guarantees to financial systems. An empirical analysis of Europe

EU Commission (2010), “State Aid Scoreboard”.

Honohan, Patrick and Philip Lane (2009), “Ireland in crisis”, VoxEU.org, 28 February.

Kelly, Morgan (2010), “Whatever happened to Ireland”, VoxEU.org, 17 May.


1 Data on the amounts of money committed by the European Governments in bank rescue packages are taken from the EU Commission )2010).

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Topics:  EU policies Europe's nations and regions

Tags:  Ireland, bank bailouts, Fiscal crisis, Eurozone crisis

Associate Professor of Economics, Catholic University of Milan

Professor of Financial Mathematics, University of Bologna

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