Bank bailouts
Banks play a vital role in our present economic system so it should not come as a surprise
that, when they are threatened, states sit up and take interest. What may be surprising is
just how far governments and central banks are willing to go to ensure that the banking
sector does not collapse, rapidly implementing policies and deploying resources in a way
that it is difficult to imagine happening were any other specific industry in danger.
The Financial Crisis bailout.
The 2007-08 financial crisis and its aftermath put the global banking system under severe
strain. As asset bubbles burst and risky gambles failed, banks across the world found
themselves with huge holes on their balance sheets, struggled to find liquidity and sharply
cut back their lending operations, causing a credit crunch which devastated the economy.
Desperate to avoid even worse economic fallout, governments across the world stepped in
to prop up big banks and ensure their survival, the UK Government among them. In total,
between 2007-10 the Government made £1,162 billion available to UK banks according to
a review by the National Audit Office (NAO). This was made up of £133 billion in direct
cash outlays – loans and purchasing share capital – while the vast majority, £1,029 billion,
came in the form of guarantees and other forms of non-cash support. The two biggest
recipients were Lloyds and RBS who had to be recapitalised, with the Government
purchasing shares (41% of Lloyds and 83% of RBS) in exchange for cash and
guaranteeing assets on their balance sheets; in total they received £276 billion and £256
billion respectively – roughly half of the total support offered. Other UK banks benefited
from sector wide schemes and so did some non-UK banks which had significant UK
operations; three insolvent Icelandic banks received loans to enable them to repay
deposits. £106 billion went towards the nationalised Northern Rock and Bradford & Bingley
who had become insolvent and were unwound while their depositors were insured [link 48].
Looking at those totals – more than one trillion pounds committed – illustrates the extent of the
commitments the Government was willing to make, but it is not necessarily an
accurate representation of the actual cost of these actions. As described above, the bulk of
this total came in the form of guarantees and other support schemes, which were made
available but not actually utilised in their entirety, certainly not all at once. The £1,162
billion figure is better understood as the total capacity of the support on offer rather than as
a tally of actual expenditure.
The Office for Budget Responsibility (OBR) estimates that £137 billion was actually spent
and most of it later recouped as loans were repaid, shares and nationalised assets sold
off, and other schemes closed having turned a net profit. Ultimately, they estimate the
actual loss to the taxpayer to be ‘just’ £27 billion, most of which can be attributed to the
government’s purchase of RBS shares which have not and seem unlikely to ever recover all their
value, some of the government’s stake having already been sold at a loss [link 49].
However, this rather rosy picture of how much the bailouts cost only looks so good
with the benefit of hindsight. At the time that these interventions were made the
Government could not be certain that its spending would be repaid and that the liabilities to
which it committed itself would not end up being claimed to their fullest extent.
A question of priorities.
The extent of the support that was at least on offer to the financial sector raises the
question of inequity: why did the Government devote so much to ensuring that big banks’
balance sheets could be made whole without doing the same for households and non-
financial businesses?
The financial crisis sparked a severe recession, the fires spreading from the financial
sector across the whole economy. Unemployment rose by more than 2% [link 50], mortgage
defaults and foreclosures rose sharply - although the prevalence of adjustable-rate
mortgages in the UK saved many, as the Bank of England rapidly cut interest rates - [link 51], and
there was a wave of bankruptcies – both individual and corporate [link 52]. Even as the economy
recovered, wages and productivity remained depressed for a long time [link 53], with real
wages continuing to fall until 2014 and other indicators such as mortgage approvals and
manufacturing output still below pre-crisis levels a decade later [link 54]. By contrast, the profit
margins of top investment banks recovered to pre-crisis levels by 2017 [link 55] and UK banks
subsequently increased their profits by a third by 2019 [link 56].
To be fair, part of the justification for the bailout was to help households and
businesses in some ways. Many of the interventions involved had the explicit goal of
insuring depositors to protect them from the collapse of their banks, and the scale of
intervention was largely justified on the basis that allowing banks to collapse would have
precipitated an even worse recession, potentially even a depression [link 57]. Nevertheless,
seeing a financial crisis ultimately lead to the financial sector being made whole and doing
better than ever while so many households and businesses were ruined can justifiably
lead to scepticism about the policy response.
The salience of this question about equity resurfaces when we examine the policy
response to the Covid-19 pandemic and resultant economic shock. On this occasion the
Government has essentially bailed out workers and businesses with a wide variety of
measures, including the furlough scheme to protect jobs and ensure that workers whose
employers are temporarily shuttered are still paid, as well as a range of loan and support
schemes to allow businesses access to credit throughout the crisis [link 58].
The NAO estimates that the cost of these measures, as of August 2020, already stood at about £210 billion [ink 59].
These radical measures are justifiable on the basis that the sharp drop in economic activity
that has resulted from the pandemic itself, as well as lockdown measures to try and slow its
spread [link 60], will hopefully be temporary and means that households and businesses are not
responsible for the difficulties they are experiencing; therefore they should be kept afloat
for the duration of the crisis as much as possible. But, if this kind of general bailout is
acceptable now, why wasn’t it before? From the perspective of most economic actors a
global pandemic and a global financial crisis are similar prospects: huge external shocks
that they had nothing to do with causing. So if we should be shepherded through one, why
not the other? Or more precisely – why only banks in the other case?
Too big to fail.
As mentioned, a key argument in favour of the bank bailouts was that not doing them
would just have made the financial and economic crisis even worse. The crisis revealed
the extent to which the world’s biggest banks were integral to the global financial system,
not just because of their size and the increasing concentration of the sector into just a few
huge institutions, but also because of their interconnectedness: the biggest banks were
tied together by a web of deals, guarantees, loans and short-term funding, which meant
that the failure of one would impose substantial losses upon the others [link 61]. Governments
and central banks were terrified by the prospect of a kind of domino effect: one big bank
collapse leads to another collapsing, and then another, and so on until the entire financial
system has completely broken down. The big banks were simply “too big to fail”.
Too big to fail is not a Titanic-style boast that the size of these banks made them
invulnerable; the financial crisis clearly demonstrated that they were not. Rather it
encapsulated the belief that the survival and continued operation of these banks was so
crucial to the health of the overall economy that their going out of business would be
catastrophic, therefore, governments had no choice but to bail them out [link 62]. Too big to fail
really means too big to be allowed to fail.
An illustrative example of the risks of not bailing out big banks was provided by the
collapse of Lehman Brothers in September 2008. At the time of its collapse Lehman was
the fourth-largest US investment bank, had $639 billion in assets and employed 25,000
people worldwide. In the years leading up to the crisis Lehman had overexposed itself to
the subprime mortgage market. When that bubble collapsed Lehman found itself suffering
huge losses, its share price fell dramatically, and it struggled to find creditors willing to
provide it with the short-term funding it needed to survive. The US Government declined to
step in with public funds, private takeover attempts were unsuccessful, and Lehman
declared bankruptcy [link 63].
The Lehman Brothers bankruptcy sent shockwaves across financial markets.
The immediate impact was to send stock markets tumbling and to undermine confidence in
many of the other financial institutions which owned Lehman’s debt and which were also exposed to the
subprime mortgage market which had brought Lehman down. Soon, panicked investors staged a run on money market funds, which were crucial not just to banks but which also funded the day-to-day operations of many non-financial businesses.
The economy as a whole was weeks from grinding to a halt [link 64]. This nadir of the financial
crisis was not solely caused by Lehman’s failure – other big institutions like AIG were in
trouble regardless of what happened to Lehman [link 65] - but it certainly did not help.
Moral hazard.
If big banks are too big to fail, and they know that they are too big to fail, then their status
may create a problem, whereby they are incentivised to engage in excessive risk-taking
because they know that if they encounter serious existential problems then the public
sector will step in to ensure they survive. They do not really face the prospect of going out
of business if they make bad decisions. At worst they will suffer some losses which they
can try and recoup later. This perverse incentive is called ‘moral hazard’ [link 66].
If moral hazard is prevalent in the financial sector then it may encourage the kind of risk-
taking and over-leveraging that causes financial crises in the first place. Ironically, the
act of insuring against financial crises may help cause them. In the academic literature
there is some evidence that government guarantees contribute towards increased risk-
taking by banks [link 67] and are associated with a greater likelihood of banks experiencing
distress [link 68]. However, there is also a countervailing argument that public safety nets help
increase the value of banks as they survive for longer which contributes to self-discipline,
as bigger banks have more to lose, since even partial losses would be very large and
would damage their stock [link 69].
Moral hazard extends beyond banks too. Wealthy depositors and other stakeholders
effectively have their interests insured if their bank achieves too big to fail status as well.
The risk of failure and loss is meant to discipline banks and their customers into making
prudent decisions. The promise of being bailed out naturally pushes their behaviour
towards taking more risk, safe in the knowledge that things won’t be allowed to go too
badly for them.
Making banks responsible.
It does not seem desirable or equitable to have the fortunes of the economy dependent
upon the fates of a few massive private financial firms, which have to be propped up at all
costs and yet nevertheless, over the long run, continue to rake in huge profits. However, if
that is the situation we are in, it also does not seem prudent to allow banks which really are so
important to collapse if (when) another severe financial crisis arises. So how can we
extract ourselves from this situation and push banks to bear greater responsibility for
themselves without blowing up the economy in the process?
Break up big banks.
​
If banks are too big to fail, inasmuch as their preservation is an economic
imperative, then surely they are too big? A straightforward, at least in theory, long-term
solution would be to prevent any bank from reaching that status. In the aftermath of the
financial crisis a wide range of economists, financiers, central bankers and even
commercial banking executives endorsed calls to break up the biggest banks [link 70]. The Nobel
Prize-winning economist Joseph Stiglitz wrote in 2009 that the size of banks should be
limited so that they can be allowed to fail, noting that 106 small American banks had gone
bankrupt that year even as Wall Street giants were kept alive [link 71]. More recently, the left-wing
Senator Bernie Sanders proposed legislation to cap the size of banks at 3% of GDP [link 72].
If banks are “too big to fail” then perhaps that means they are “too big to exist”?
Some have argued against breaking up too big to fail banks. As mentioned above there is
the line of thought that the increased value of huge banks itself acts as an incentive
against taking too much risk. There may also be economies of scale in the banking
industry, such that bigger banks are more efficient, the benefits of which may be passed on
in the form of cheaper access for customers, and may also help facilitate international
trade [link 73].
Protect customers.
​
The main reason that the collapse of big banks would be so disastrous
to the economy is the amount of money that would simply disappear. The functional role of
commercial banks in the modern economy is that they create the vast majority – about
80% [link 74] - of the money that circulates in the form of bank deposits, either in exchange for
money paid in or by issuing loans. Typically, only a fraction of a bank’s deposits are
covered by “base money” – physical cash or central bank reserves – while the rest has to
be provided by market operations, as well as the assumption that loans will be repaid and
that, at any given time, only some of their customers want some of their money [link 75].
If a financial crisis caused the collapse of one or multiple big banks then the consequence
would be that a vast amount of money held in bank deposits would be gone. Customers
who have deposited their paycheques with, accumulated savings at, or borrowed from a
failed bank would find that their money no longer exists. If customers’ deposits were
sufficiently insured against such a scenario then it would not matter so much if even the
biggest banks failed. Indeed, in the UK bank deposits at regulated institutions are insured
by the FSCS up to a maximum of £85,000 per person if the bank fails [link 76]. An even more
comprehensive system might effectively neuter the threat of bank collapses to the wider
economy.
Allow for orderly failure.
​
Part of the justification for bailouts during the financial crisis was that no existing resolution
process could adequately cope with being applied to a big bank or financial institution.
The only alternative to bailouts was ordinary corporate insolvency, which would have most likely
resulted in the day-to-day activity of the bank, which so many households and businesses are reliant
upon, being unacceptably disrupted. Had an option more tailored to unwinding an insolvent bank been available then perhaps both a disastrous collapse and a costly bailout could have been avoided.
The Bank of England is responsible for the prudential regulation of UK banks and other
financial institutions, setting standards such as capital requirements and mandating a
certain standard of risk preparedness [link 77]. Since the financial crisis these regulations have
been the subject of criticism and reforms such as “bail-ins”, which are intended to make
sure that the costs of future bank failures are born by stakeholders without recourse to
public funds and have been introduced in the hope of avoiding a repeat of the bailouts [link 78]. This
process is untested, at least in the UK, and there is always the risk that reforms in
response to the last crisis fail to anticipate the problems posed by the next. The UK
financial sector is still dominated by a few huge firms – the “big four” of Barclays, HSBC,
Lloyds and NatWest – and some stricter regulations brought in since 2008 have helped
entrench this, as only the biggest banks have the resources to meet higher standards [link 79].
The Bank of England ought to be bolder about regulating the financial sector and, if
necessary, breaking up too big to fail banks for the sake of general financial and monetary
stability.
​
48 https://www.nao.org.uk/highlights/taxpayer-support-for-uk-banks-faqs/
49 https://obr.uk/efo/economic-and-fiscal-outlook-march-2020/ (table 3.39/pg. 147)
50 https://www.ons.gov.uk/employmentandlabourmarket/peoplenotinwork/unemployment/timeseries/mgsx/l
ms
51 https://voxeu.org/article/mortgage-delinquency-and-foreclosure-uk
52 https://www.independent.co.uk/news/uk/home-news/record-numbers-are-declared-bankrupt-as-
recession-bites-1570698.html
53 http://eprints.lse.ac.uk/65615/1/Coulter_The%20UK%20labour%20market%20and%20the%20great%20
recession.pdf
54 https://uk.reuters.com/article/uk-britain-economy-crisis-graphic/britains-lasting-scars-from-the-financial-
crisis-idUKKCN1LX0FY
55 https://www.ft.com/content/47661792-68a6-11e8-8cf3-0c230fa67aec
56 https://www.thisismoney.co.uk/money/markets/article-7198523/How-Britains-biggest-banks-posted-
bumper-combined-profit-22bn-year.html
57 http://news.bbc.co.uk/1/hi/8394393.stm
58 https://www.gov.uk/government/collections/financial-support-for-businesses-during-coronavirus-covid-19
59 https://www.nao.org.uk/covid-19/cost-tracker/
60 https://www.bbc.co.uk/news/business-53748278
62 https://www.investopedia.com/terms/t/too-big-to-fail.asp
63 https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp
64 https://www.thebalance.com/lehman-brothers-collapse-causes-impact-4842338
66 https://www.investopedia.com/terms/m/moralhazard.asp
67 https://academic.oup.com/jfr/article/1/1/30/2357860#206793164
68 https://academic.oup.com/rfs/article-abstract/25/8/2343/1569941?redirectedFrom=fulltext
69 https://onlinelibrary.wiley.com/doi/abs/10.1111/kykl.12044
71 https://www.project-syndicate.org/commentary/too-big-to-live?barrier=accesspaylog
72 https://www.project-syndicate.org/commentary/too-big-to-live?barrier=accesspaylog
73 https://www.brookings.edu/research/the-big-bank-theory-breaking-down-the-breakup-arguments/
74 https://www.bankofengland.co.uk/knowledgebank/how-is-money-created
76 https://www.fscs.org.uk/what-we-cover/banks-building-societies/
77 https://www.bankofengland.co.uk/prudential-regulation
78 https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2015/bank-failure-and-bail-in-an-
introduction.pdf
79 https://www.ft.com/content/77ef93ec-e100-11e9-9743-db5a370481bc