Banking produces a particular form of social pollution – financial crises. We have had many hundreds of years of experience of such crises. The global financial crisis will, however, almost certainly require a re-think of their costs. The cumulative GDP costs of the crisis so far in the US, UK and the euro-area are well in excess of 25% of GDP (Chart 8). In net present value terms, they could easily end up equating to a year’s GDP or more. This suggests, pre-crisis, the misalignment between private and social incentives in banking was larger than perhaps at any time in the recent past. In the language of Jensen and Meckling, risk had been shifted by management and shareholders onto a much wider set of societal stakeholders, with significantly adverse macro-economic implications. (b)  Moral hazard  That brings me to the final of the incentive frictions. When the social costs of an activity are high, as during financial crises, there are strong incentives to cushion the effects on wider society. The global financial crisis provides no better example of those incentives, with extraordinary levels of government support to the global banking system in the form of recapitalisation, liquidity support and guarantees. BIS central bankers’ speeches  11  While these levels of support were arguably necessary to limit the costs of the crisis, they came with their own longer-term costs.
The most important of those costs was probably the adverse effects of such interventions on risk-taking incentives – in other words, the moral hazard of government insurance (Alessandri and Haldane (2009)). This is not a new issue. The historical evolution of the financial system has been a game of cat and mouse between the state and the banking system (Haldane (2010)). Because the cat has typically failed to keep pace with the mouse, the result has been a widening and deepening of support mechanisms for banks over time. Elsewhere, I have called this dynamic link between bank and sovereign balance sheets the “doom loop” (Haldane (2012)). One measure of the extent of this problem is found in estimates of the “implicit subsidy” banks earn as a result of the expectation of government support. Chart 9 plots one measure of this “implicit subsidy” to UK banks. This peaked following the bail-outs at a remarkable £ in 2009. Since then, it has fallen substantially – to around £ in 2013 – as regulatory reforms have been put in place to constrain risk-taking and the financial strength of banks has improved. But it remains in positive territory, suggesting an on-going distortion to risk-taking incentives. Public policy responses The modern company harbours a range of micro-economic frictions. In some cases, these seem likely to have generated significant macro-economic costs, in the form of sub-optimally low rates of investment and sub-optimally high degrees of risk-taking.