In this revision video we look at arguments for and against bailing-out the banking system during a financial crisis.
The UK government under Chancellor Alistair Darling and Prime Minister Gordon Brown took the decision to launch a multi-billion-pound bail out of the financial system during the Global Financial Crisis which reached a peak in the Autumn of 2008 with the bankruptcy of Lehman Bros in the United States. Four major commercial banks were given a financial life-line although not every bank required one, for example Barclays (later to become mired in controversies of its own).
Total spend on UK bank bail outs estimated at £137 billion, net spend is around £23 billion (Source: 2018 Parliamentary Research Reports)
What are the main arguments in support of a national government deciding to bail out commercial banks who are making heavy losses and at risk of collapse?
Key argument: Protecting against systemic risk
Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could then trigger instability or collapse an entire industry or economy.
Key argument - moral hazard
Moral hazard happens when an agent is given an implicit guarantee of support in the event of making a loss – e.g. insurance pay-outs or state bail-outs for failing banks.
This can cause the agent to change their behaviour and take higher risks knowing that they have an insurance in hand.
“Profits are privatised whilst losses are socialised”
Case for bail out may depend on significance of financial sector to a country e.g. UK City of London, risk of capital flight, exports of financial services, banking profits as a source of tax revenues
The US and UK chose a bail-out approach (although LehmanBros could go bankrupt) + measures/tests to improve banking resilience at times of stress
Bail-outs have now largely been replaced by bail-ins - e.g. commercial bank issue bonds which are converted into equity if a bank’s losses wipe out their capital buffers / reserves
Iceland’s three leading banks defaulted in 2008 – government nationalised them and then liquidated them – this came at a severe short-term economic cost
Alternatives to bail-outs include tougher rules on lending (e.g. for housing mortgages) and supply-side reforms to encourage new banks into the industry
© 2022 Tutor2u Limited. Company Reg no: 04489574. VAT reg no 816865400.