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Economics of Commercial Bank Bailouts

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 27 Mar 2023

In this revision video we look at arguments for and against bailing-out the banking system during a financial crisis.

Economics of Commercial Bank Bailouts

UK Commercial Bank Bailouts from 2008 onwards

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).

  • Royal Bank of Scotland (government acquired 84%) – still retains around 60%
  • Lloyds Banking Group (government acquired 43%) – all shares now sold
  • Northern Rock (100% nationalised) – sold to Virgin Money (2012)
  • Bradford and Bingley (100% nationalised - 2010, Bradford & Bingley was renamed Santander UK

Total spend on UK bank bail outs estimated at £137 billion, net spend is around £23 billion (Source: 2018 Parliamentary Research Reports)

Justifications for bank bail-outs

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?

  1. Negative multiplier effects on AD & growth from thousands of banking jobs lost
  2. Banking collapse might squeeze lending to small and medium-sized businesses who need to borrow money to stay in business or finance capital investment
  3. Savers and pensioners are at risk if commercial banks fail – this might worsen poverty and lead to increased pressure on government welfare payments
  4. Severe drop in confidence (animal spirits) and loss of trust in the financial system risks a deflationary depression rather than a cyclical recession
  5. Money spent on bail-outs can be recouped as the economy recovers – so the net cost is likely to be smaller as the government unwinds the bail-out

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.

Evaluation: Arguments against government bail-outs

  1. Bail-outs increase government borrowing and the national debt which risks causing higher market interest rates and increased taxes in the future
  2. Funds tied up in a bail-out could be used to invest in infrastructure or health & education services (big opportunity cost)
  3. Moral hazard argument – bailing out a commercial bank may influence their behaviour causing them to take higher risks in the future
  4. Equity issues – why should taxpayers pay the price for a bail-out? Are banks that different from steelworks, airlines, travel companies or loss-making retailers?
  5. Austrian school – Economists such as Hayek argued that allowing loss-making banks to fail is part of the normal process of capitalism – new banks will take their place perhaps with less risky business models. Bail-outs are a form of government failure.

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”

More context for the evaluation

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

Bank failures can have a number of negative consequences, including:

  • Loss of jobs: Bank failures can lead to job losses, as employees are laid off.
  • Loss of savings: Depositors can lose money if their bank fails, as their deposits are not insured by the Federal Deposit Insurance Corporation (FDIC).
  • Loss of credit: Bank failures can make it difficult for businesses to get loans, as lenders become more cautious about lending money.
  • Financial instability: Bank failures can contribute to financial instability, as they can lead to a loss of confidence in the banking system.

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