05 June 2011

How Much Does Financial Sector Add to Public Debt?

One of the not so much discussed reasons of the recent financial crisis was that banks were (and still are) benefiting from the explicit and implicit public sector guarantees. Many people were (are) not caring about the risk level of their bank as they were (are) hoping to the compensations from the deposit guarantee schemes should a bank go broke. Lenders and debt investors on the other hand were (are) expecting that large banks are not being let to bankrupt; they know that there is not enough funds to compensate to depositors in case a systemically important financial institution would collapse. This has made money cheap for the banks and led them to use it carelessly. The obscure part here is that in widely considered government debt statistics (gross and net debt of general government) such off-balance-sheet liabilities of the public sector are not included. We only use to see and talk about them when it’s too late already.

For Europeans one the most vivid examples of potential financial sector impact to the government’s debt is perhaps Ireland, the country that seemed so successful just a few years ago but recorded an astonishing government budget deficit of 32.4% of GDP or EUR 49.9bn in 2010 (data source: Eurostat). Approximately EUR 46bn of this deficit had to do with the rescue of Ireland’s stricken banks. According to Irish Bank Stress Test published on 31 March 2011, at least EUR 24bn is still needed for recapitalising the four largest Irish banks.  

Another rather extreme example is the Icelandic Crisis in September/October 2008 when the three largest Icelandic banks, Kaupþing banki hf (also known as Kaupthing bank), Landsbanki Íslands hf and Glitnir banki hf, experienced difficulties and were unable to refinance about GBP 35bn of debt. All three were nationalised by the Icelandic authorities and thus added to the public sector liabilities.

There are two important points I want to highlight in relation to financial sector’s impact to public debt:
1) the significant impact of the financial sector to the public sector liabilities that is not reflected in a government’s debt statistics, and
2) government’s off-balance-sheet liabilities that may easily become on-balance-sheet debts.

Regarding the first point note, that general government only includes central government and local governments. The country’s central bank and public sector corporations are not taken into account. Among others this means that if a bank is nationalised or any “bad bank” or SPE (Special Purpose Entity) created by the state, we won’t see the impact in government’s statistics. Public sector debt however increases accordingly. A good example here is UK where:
* the generally considered government net debt amounted to 60.1% of GDP (GBP 910.1m) as of April 2011, and
* the respective public sector net debt amounted to 148.9% of GDP (GBP 2 252.9m) – barely worth an AAA rating
(see the numbers published by HM Treasury). The difference between these two numbers mainly results from the reclassification of the failed Royal Bank of Scotland Group plc, Lloyds Banking Group plc, Northern Rock plc and Bradford and Bingley plc (bailed out by the government during the financial crisis) as public financial corporations. So the financial sector’s add-on to public net debt for UK has been at least GBP 1 343bn or 88.8% of GDP.

What concerns government’s off-balance-sheet liabilities, consider for example the European Financial Stability Facility (ESFS). Although potential liabilities are backed by the irrevocable and unconditional guarantees of the Euro Area Member States up to the amount of EUR 440bn, they are only recognised in public statistics until someone of the Member States has already de facto defaulted and a loan has been disbursed. Obviously we would like to see an estimate of the total liabilities arising from such guarantees. It is the very same thing with the deposit guarantees: one would like to be clear if there is enough money for possible bank failures and if not then what is the potential amount of liabilities for the government.

So, how much does the financial sector add to the public debt? We still don’t know exactly but we do know from experience that this is a large amount. For going forward, the very first thing to do is to consider public debt instead of government debt. Secondly, there have to be reliable statistics about all the off-balance-sheet liabilities of a country.

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