Wednesday, October 1, 2008

Why We Need to Bailout Banks

Bailing out a bank, is rather like going to the dentist to have a tooth pulled out. We hate having to do it, but, if we don't deal with the rotten tooth we feel we will only suffer more pain in the long term.

Quite a few readers ask, why should we bail out irresponsible banks, when we don't bailout manufacturing firms?

If a commercial bank like Halifax in the UK risked going bankrupt, savers would rush to get their money out. Last year, queues of people went to Northern Rock to withdraw their money (even though Northern Rock's problems was raising finance for mortgage sector)

The problem is that Halifax wouldn't have enough deposits to cover savers demands. Banks only keep a certain % of their deposits in cash. About 99% will be lent out in the form of mortgages and loans. The Halifax can't call this back at short notice therefore, people would be unable to get their cash out.

If people hear that others have lost their bank savings, they will want to withdraw their money from their bank - just in case it goes under. The panic and desire to withdraw your cash would spread throughout the banking system. Even banks which were relatively sound, would have large queues of people wanting to withdraw their money. (It is an irony, that what makes sense for you to do, creates problems for society)

If this happened the whole banking system could collapse. The banking system relies on confidence. It relies on the fact people won't want to withdraw their money all at once. If people do try to withdraw money, the bank will be incapable of dealing with it. If this happens, banks would not be able to lend money to consumers and firms to invest. It would cause a contraction in economic growth, and we could enter into a serious recession.

This kind of bank rush did occur in the Great Depression, and it is widely considered to have exacerbated the Great Depression. Therefore, there is a powerful precedent to avoid it happening again.

But What About Intermediary Banks?

Many banks which have shortage of liquidity are not commercial banks with savings, but investment banks like Lehman Brothers, Morgan Stanley or even Insurance Giants like AIG, who have been insuring bonds and bank loans. The problem is that commercial banks rely on interbank lending. They rely on being able to borrow from intermediaries on money markets to raise funds. These days banks lend more money than they have in savings. If the intermediary banks go under, it will worsen the balance sheet of all commercial banks and make it more likely they suffer from liquidity shortages.

As much as we dislike bailing out rich bankers, the problem is we don't want to see a situation where people stop using the banking system and the banking system is unable to lend money. This would cause a real economic downturn. Already business investment has been affected by a shortage of finance. If this was to significantly worsen, the recession could change into a depression.

Does That Mean Paulson's $700bn Plan is Good?

Not necessarily, just because we want to protect the banking system, it doesn't mean we have to go along with the first scheme which comes along. It is debatable whether buying worthless assets will do much to help. There may be better ways to prevent a banking collapse. - Questions about bailout

See also: Argument against bailing out banks
(BTW: This is the 500th post on this blog Economics Essays)

1 comment:

Thatch said...

I understand what you say, but it makes me mad. Anyway here's what I posted this morning on
Tuning in to the Today programme this morning I learned that the Government had announced its latest rescue package for UK banks.
The Government is going to make £50b available for banks to access if they require funds to shore up their capital. This is likely to be in the form of preference shares. The first question is where is the cash coming from if as we are being told constantly, the government has no available cash. Presumably it is borrowing this from the market place, that same market place that won't lend to other banks.
Secondly, what is the upside here for the British taxpayer? Bank shares are at a ten year low. Presumably over the medium term, with the guarantee of government support and a pledge that "we will do all that is necessary" these bank shares will rise considerably in value. Is the British tax payer getting the type of share that can be sold in due course and the benefit of the increase in share price realised?
The second element of the rescue is that the government looks like it is going to provide a guarantee for a bank which has to the market to replace it's short term borrowing used to fund its long term mortgage lending. eg HBOS may need to replace £100b of this type of funding in the next three years or so. If the money market will not replace this borrowing the government intends to act as guarantor for the banks ability to meet any repayments on this money, and to bolster the security given to secure it. Again, any shortfall on the security will be picked up by the British taxpayer!
My question this morning is whether the market will see fit to accept this latest offer. The government and the Bank of England have been intervening for months now by providing cash for liquidity, to little effect. This is a bigger plunge, and is significant, but the market is not driven by sentiment. My worry is that the market will effectively say, "Thanks British Government, that is a nice offer, but we think that you can go higher". Essentially they will play a game of poker and see just how far they can push not only our government but others around the world. If I am right and this is like poker, have we revealed our hand too early, and what else have we got to offer. Actually shouldn't we be calling the markets bluff and saying, that's it. Take it or leave it, there is no more.