Bailout for Dummies

Though it seems evident that banking crises incur huge costs on the affected societies it is far less evident how to measure these costs. For example, it is not clear how much output loss can be attributed to a banking crisis and how much is due to the recession that often precedes the outbreak of a banking crisis. Moreover it is not clear how to value possible changes in inequality and confidence of economic actors or the effects of unemployment on human capital . Notwithstanding these difficulties, two measures, fiscal costs and output loss, are commonly used and will be presented below.

Banking crises have detrimental effects on the rest of the economy. Banking crises usually result in severe economic crises with negative GDP growth, frequent bankruptcies, high unemployment and often social and political turmoil. A possible breakdown of the whole payment system, capital flight and higher probability of currency crises, as well as a general loss of confidence add to the list.

Bailouts of insolvent banks to avoid spreading of bank insolvencies put a heavy burden on the budget and can increase social inequality by transferring money from tax payers to depositors. Budget deficits constrain future government spending and can result into inflationary monetary policy thereby imposing an additional inflation tax on tax payers. Bailouts can distort economic incentive schemes by keeping inefficient banks alive and therefore reducing the motivation of managers to act efficiently and of depositors to choose banks cautiously, thus preparing the ground for future banking crises.

At this point there is an agreement among economists that banking crisis causes higher losses for developing countries than for developed countries that have well-developed banking system and efficient supervisory schemes.

By “bank bailout” economists refer to the provision of funds to the bankrupt or nearly bankrupt bank in order to increase its liquidity (in other words provide additional cash) and prevent bankruptcy of the financial institution. Generally bailouts are made by government or by private investors willing to take over the troubled institution in exchange for the funds provided.

LOLR function is one of the basic functions of the central bank in the context of their role of banking sector supervising entities. Ideally LOLR function is used by central banks in order to solve temporary liquidity problems (cash problems) of the banking institutions. As liquidity problem within the bank arises, the bank tries to borrow funds from other banks. In case it manages to do so, the problem is automatically solved. However LOLR function existence has a justification that during systemic crisis normal financial relations are hampered and a banks requiring borrowing cannot manage to receive funds. If the bank fails to raise funds, it faces serious threat of getting bankrupt. So there must be some institution that will provide credit to the troubled bank.  In this case central bank lends to the troubled bank in order to solve temporary liquidity problems of the offshore banking institution.

So why authorities cannot just let the bank go bankrupt? Because bank failures have externalities – negative effects on other market players. They often impose heavy burden on other market participants. For instance client companies of failed banks often experience drop in the share value on stock exchange. This is because potential investors think that failed bank may have clients with poor financial standing.

In addition, bank failure has a domino effect: if one bank fails, there is a risk that it may spread to entire banking system. Depositors of other commercial banks may start thinking that failure of one bank is just a beginning and due to false expectation may create a “bank run” – a situation, when depositors massively withdraw deposits from the banks that are characterized by large queues in front of the bank offices.

The last, but not least is cost of bailout. First of all during bailout taxpayers’ money is transferred to the depositors and second bailout creates a moral hazard: an institution that receives funds for bailout get an impression that next time crisis occurs authorities will come to help again. Consequently the bank starts favoring high risk-high return projects that tends to be very dangerous for the overall stability of the banking sector in long-run. If this happens, the system may be become absolutely unsustainable, since funds required for bank bailout will rise each time.