Is letting banks fail a good idea?

The history of bailouts might repeat in the COVID-19 Crisis. If the recession lasts long, equities of financial agencies cannot stand.

Unfortunately, it is a must to save financial institutions although doing so is risking the taxpayer’s money.

The moral hazard problem of bailouts would be addressed by penalizing rescued financial institutions once they better off.

Governments could convince their people in favor of bailout if rescued financial agencies paid the premium of risking taxpayer’s money

A new financial crisis is approaching

As set forth here, governments should not allow a retrenchment in expenditure in COVID-19 times. If a recession lasts long, equities of financial agencies cannot stand losses from delinquencies after a while. Eventually, governments will have to bail out financial agencies via capital injections. Is it really necessary to bail out financial agencies?

Unfortunately, it is a must to save financial institutions although doing so is risking the taxpayer’s money. In 2008, the bailout of AIG was among the most extraordinary ones. The Fed provided liquidity to AIG taking preferred dividends of AIG subsidiaries, ALICO and AIA, as collateral (Reuters 2012). That is, if AIG had failed, the Fed would have automatically become the shareholder of the companies. Eventually, financial institutions paid their debts to the Fed and the government.

What if authorities let financial agencies fail such as ordinary entreprises? In the crisis time, fail of a financial actor might trigger a domino effect. The 2008 Global Financial Crisis escalated once the US Treasury did not rescue Lehman Brothers. The Fed Chair, Ben Bernanke stated that 12 out of 13 most important financial institutions in the US were at risk of failure within a week or two (CNBC 2011). The Fed and Treasury rescued all of them. If financial agencies had failed, the channel to finance households and firms would have collapsed. In such a scenario, countless firms and individuals would have declared bankruptcy. It is not easy to establish a firm from scatch. It would have taken years to restore the production capacity and demand. The economy would have experienced recession and inflation meanwhile since the fall in demand would have been accompanied with a loss in production capacity. This is why the financial system cannot be allowed to collapse.

Though, rescue operations are not popular. Obama lost 2010 elections although the economy had recovered in two years time (Huey-Booms 2010). Moral hazard of bailouts was one of the reasons of the political failure. Taxpayers naturally do not want to risk their money in return of nothing. Ordinary citizens have to pay an extra premium when they fail to meet their financial obligations; yet, financial institutions, which are run by professionals being paid millions of dollars per month, are rewarded via lower interest rates in the crisis time.

Walter Bagehot was one of the first who wrote about the lender of last resort mechanism during the crisis. According to him, a central bank should lend at a penalty in the crisis time (Bignon et. al. 2012). His argument conflicts with the expansionary characteristics of crisis intervention. A higher interest rate would not serve to reduce interest rates and stimulate expenditure. However, penalties can be exercised once the crisis is over. Rescued financial institutions would be penalized once they bettered off. Thus, the moral hazard problem would be addressed. If rescued financial agencies paid the premium of risking taxpayer’s money, governments could convince their people in favor of bailout.

In the absence of a penalty, weak government incentive to bail out could lead to hesitations. During the crisis time, acting a few days later might be too late for rescue operations and lead to the collapse of the entire financial system. Therefore, ways to gain public support should be sought.

References

Bignon, Vincent, Marc Flandreau, and Stefano Ugolini. 2012. Bagehot for Beginners: The Making of Lender of Last Resort Operations in the Mid-Nineteenth Century. https://halshs.archives-ouvertes.fr/halshs-00844045/document

Carney, John. 2011. Bernanke’s Mystery: 12 Out of 13 Major Firms at Risk in 2008. CNBC. https://www.cnbc.com/id/41310901

Huey-Booms, Caitlin 2010. 2010 Election Poll Roundup: Obama Approval Rating Hits a New Low. https://www.usnews.com/news/articles/2010/10/21/2010-election-poll-roundup-obama-approval-rating-hits-a-new-low

Reuters. 2012. Timeline-The Government's Rescue and Sale of AIG. https://www.reuters.com/article/aig-treasury-idUSL1E8K93M820120909