Why don’t we let Banks Fail?

November 13, 2011
Ziad K. Abdelnour

Financial Strategies and Economic Policy

This blog explores the reasons behind government interventions to prevent bank failures, such as the perceived necessity to maintain financial stability and protect the broader economy. It critically assesses the implications of such interventions, including moral hazard and the potential undermining of market discipline. The author debates the merits of allowing market forces to play out, suggesting that controlled failures might ultimately lead to a more resilient financial system.

Bloomberg had a story, a couple of days ago, about BofA moving Merrill Lynch derivatives to its retail-banking subsidiary.

The story was quite long and hard to follow: there were lots of detours into explanations of what a derivative is, or explorations of what the BAC stock price was doing that day.

It seems that regulators care much more about Bank of America, the retail-banking subsidiary which holds depositors’ money, than they do about BAC, the holding company which owns Merrill Lynch. And the senior executives at Bank of America have a fiduciary duty to Bank of America — never mind the fact that their shareholdings are in BAC.

The Fed, in allowing and indeed encouraging this transfer to go ahead, is placing the health of BAC above the health of Bank of America. And that’s just wrong. Holding companies can come and go — it’s the retail-banking subsidiaries which we have to be concerned about. The Fed should not ever let risk get transferred gratuitously from one part of the BAC empire into the retail sub unless there’s a very good reason. And I see no such reason.

Comparing this to the Iceland banking crisis and three years after the collapse of their banking system and the country teetering on the brink, Iceland’s economy is recovering, proof that governments should let failing lenders go bust and protect taxpayers.

In fact, the lesson that could be learned from Iceland’s way of handling its crisis is that it is important to shield taxpayers and government finances from bearing the cost of a financial crisis to the extent possible.

Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. It imposed temporary controls on the movement of capital to give itself room to maneuver. No wonder it is doing today much better than virtually all of the countries which have let the banks push them around.

Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

Countries with larger banking systems can follow Iceland’s example.

As the first country to experience the full force of the global economic crisis, Iceland is now held up as an example by some of how to overcome deep economic dislocation without undoing the social fabric.

While the conditions in Iceland are in many ways different from the conditions in the U.S., Iceland’s lesson applies to America, as well.

Specifically, a study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

Bottom Line: I still strongly believe that our economy cannot and will not recover until the big banks are broken up.

If the politicians are too corrupt to break up the big banks (because the banks have literally bought them), why don’t we break them up ourselves?

Your feedback is as always greatly appreciated.

Thanks much for your consideration.

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