FT Alphaville " How much an implicit banking subsidy? The Bank of England has taken another crack at estimating the cost (or value, depending on your point of view) of the implicit subsidies given by the state to various banks. The full paper, with a much more detailed look at methodology, is here. We will just bring you a little snapshot of Noss and Sowerbutts" work. They point out that estimates of the implicit subsidy to major UK banks vary from around £6bn (Oxera 2011) to over £100bn (Bank ofEngland 2010), and first attempt to explain the difference before proposing a new alternative means of measurement. For those who want to skip to the end, the final figures they arrive at for 2010 vary between £30bn and £120bn #cheatsheet The standard approaches to modelling the costs of implicit subsidies are split into two types: First, "funding advantage" models value the subsidy as the aggregate reduction in the cost of bank funding due to an implicit government guarantee. Second, "contingent claims" models value the subsidy as the expected payment from the government to the banking system necessary to prevent default. And according to the "funding advantage model" the implicit subsidy kicked up notably between 2008 and 2009 mainly, say the authors, due to increases in the perceived likelihood of government intervention and in banks" cost of funding. The subsidy decreases between 2009 and 2010 but the ratings uplift is unchanged. Instead, the decrease is driven entirely by a reduction in the relative difference of funding costs between lower and higher-rated firms (the steepness ofthe curves in Chart 2). Then there is the "contingent claims" approach. This approach to valuing the implicit subsidy is similar to pricing an option: The value of the implicit subsidy is analogous to that of a "put option." If banks" asset values are greater than the threshold minimum asset value when the option expires the option would not be exercised and would expire worthless. But if the value of firms" assets falls below the trigger point, the option is exercised and its pay-off is equal to the difference between the two. There are two methods for measuring the size of any payout: an option-price approach; and a, new, historical approach. Again, we recommend checking out the paper for a look at the methodology, go to page 9. The authors then compared all three options: The range of estimates is broad. The funding advantage approach estimates the implicit subsidy in 2010 to be around £40 billion. The historical and options price contingent claims methods produce estimates ofaround £30 billion and £120 billion respectively; these results value the subsidy as a look-back option discounted at a rate of 1.2%, calibrated to the distribution of bank equity prices during 2010. And, while there are significant problems with all of the approaches (which the authors quite gamely lay out) ... ... it is still worth noting that despite the massive differences between the estimates (made in this paper and elsewhere), each puts a rather large figure on the recent transfer of resources from the government to the banking system. And that has to have consequences. Related links: Financial Stability Paper No 15: The implicit subsidy of banks - Bank of England This entry was posted by David Keohane on Monday, May 28th, 2012 at 13:15 and is filed under Capital markets, People. Tagged with bank of england, subsidies.