Gains to shareholders are potentially unlimited. But the same is not true in bad states of the world. The reason is limited liability. That constrains the losses of shareholders to around zero. Losses beyond that point are borne by other parts of banks’ capital structure – wholesale and retail depositors. Therein lies the problem. If protection of depositors is felt to be a public good, these losses instead risk being borne by the state, either in the form of equity injections from the government (capital insurance), payouts to retail depositors (deposit insurance) or liquidity support to wholesale funders (liquidity insurance). The gains risk being privatised and the losses socialised. Evidence suggests this is a repeated historical pattern. Socialised losses are doubly bad for society. Taxes may not only be higher on average. They may also need to rise when they are likely to be most painful to taxpayers, namely in the aftermath of crisis. So taxes profiles will be spiky rather than smooth and will spike when the chips are down. This is the opposite to what tax theory would tells us was optimal. 13 So far, so bad. But it is about to get worse, for this tells only half the story. This is a repeated game. State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits. So it was in the run-up to the present crisis.
I don’t want to reveal too much now, but there are a few points worth considering in this context. First of all is the importance of real-time settlement, which enhances efficacy and security. This has been a feature of payment intermediation in Iceland for a decade and a half, and it is where other countries are heading. It is therefore vital that we preserve that feature during the changes now taking place. Second, it is important to keep the cost of domestic payment intermediation down. New and more diverse solutions that, for example, work directly with core financial market infrastructure, such as bank deposits and the Icelandic Banks' Data Centre’s systems, could help in this regard. Third, it is important that it be impossible to stop domestic payment intermediation through some sort of foreign intervention. Fourth, there must be alternate routes in the system, in case anything goes wrong. This could call for some diversity in payment intermediation, using different types of technology. Electronic krónur could play a role in this. But the topic of electronic krónur gives rise to big questions that must be discussed — questions about the possibilities for the general public to use electronic claims against the Central Bank (and indirectly against the State) as a medium of payment instead of bank deposits, and questions about the repercussions this could have on the role and stability of the banking system. The discussion promises to be an interesting one, and it is just beginning.