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