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Avoiding Financial Armageddon:
Bailouts
Unsurprisingly given the results, policy makers take a great interest in moral hazard as regards the financial sector: governments hate bailing it out. Bailouts are typically very expensive, very risky and very unpopular with the electorate – after all, cancelling pensioners’ free bus passes and winter fuel payments to help wealthy bankers is never going to go down well.
So if the financial sector gets into trouble, why bail it out at all? Surely, the whole point of a market economy is that badly run businesses fail and good ones succeed? When applied to the financial system, this argument seems quite attractive for about 30 seconds, until you realise that allowing a large financial institution to fail is likely to send massive shockwaves of destruction pulsating throughout the economy. This problem is called
systemic risk (for a detailed look, turn to Chapter 14).
Even in the rare cases where a large financial institution is allowed to go under (Lehman Brothers being the most well-known example – again, see Chapter 14), governments invariably attempt to bail out the rest of the financial sector in order to stop the problems from spreading and causing a cascade of failures.
Policy makers can come to the aid of a fragile financial system in a number of ways:
Lending money directly to struggling financial institutions: Central banks regularly lend money to financial institutions, even in normal times. To do so, they usually demand that high-quality collateral is posted with them (for example, AAA-rated government bonds).
As in any loan, the point of the collateral is to ensure that the borrower pays back the loan – if not, the lender keeps the collateral. But during times of crisis, banks are often short of high-quality collateral. In this case, central banks may relax the quality requirement of the collateral that they’re willing to accept in order to make loans. But doing so increases the risk of taxpayers having to incur losses.
Guaranteeing deposits: Fractional reserve banking means that if depositors lose confidence in a bank (whether the bank is actually in trouble or not), that bank is likely to experience substantial difficulties (check out Chapter 14 for more details).
In order to increase confidence in the financial system, governments can guarantee deposits. In the UK, the Financial Services Compensation Scheme (FSCS) guarantees the first £85,000 held in accounts of authorised banks, building societies and credit unions. In the US, the Federal Deposit Insurance Corporation (FDIC) similarly guarantees the first $250,000. (Trust the Americans to do things bigger and better!) In times of crisis, governments often go even further: when Northern Rock suffered a bank run in 2007, Chancellor Alistair Darling guaranteed all deposits held at Northern Rock regardless of the size.
Injecting capital directly into financial institutions: In this way,
instead of being a lender, the government takes ownership of a portion of the company. These financial institutions often find themselves in trouble in the first place because they’re undercapitalised (they don’t hold enough capital in order to safely cover any potential losses), so the idea is that if you’re going to intervene, why not intervene directly and inject fresh capital into the bank?
For example, when Royal Bank of Scotland (RBS) found itself in trouble in 2008, the UK government injected capital and thereby took a majority stake in the firm. Similarly in the US, a scheme called the Troubled Asset Relief Program (TARP) saw the government take large stakes in a number of banks.
You can see these interventions as being ‘direct’, in that they’re clearly designed to help the banking sector. But other interventions are considered to be indirect bailouts, the most prominent being the aggressive use of monetary policy. When the financial system is in a state of distress, many financial institutions and firms that rely on financial institutions suffer from liquidity problems: that is, they find borrowing money difficult. By increasing the money supply, the central bank can reduce the interest rate (see Chapter 10 for how this works) and, it hopes, make it easier for those who need to borrow money to do so.
This scenario occurred in 2008–09, when the US Federal Reserve and the Bank of England reduced official interest rates to close to zero. But even these ultra-low interest rates were seen as insufficient, and both central banks went on to pursue a policy of quantitative easing (printing money on an enormous scale) to flood financial markets with liquidity (again, take a look at Chapter 10 for an in-depth look at quantitative easing).
If all these different options are making your head spin, don’t worry. The bottom line is that if you work at, manage or are a shareholder of a large financial institution, you can be quietly confident that if you find yourself in big trouble, someone is going to come to your rescue. Or in other words, you’re just ‘too big to fail’.
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