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Discussion on whether government shold bail out banks or allow troubled banks to fail

Introduction


The years 2007-2009 witnessed one of the greatest periods of recession in the world history. It began with the U S experiencing a major financial crisis which soon mutated to the other countries resulting into a major recession. It, by and large, affected the entire world economy. As a result, many banks were bailed out, large financial institutions collapsed, businesses failed and vast unemployment spread throughout. Every sector of the society namely automobiles, construction, housing, sales were affected resulting in the bankruptcy of major banks and corporations and mass unemployment. International trade was also severely affected. In 2008, the prices of basic commodities like oil rose very high causing great economic damage.

Many countries like Malaysia which depend mostly on exports also had to undergo the recession shock. People lost their jobs and the country’s income fell. But the Malaysian banking system continued to work quite well even when the banking system of the other countries failed to function properly.

Bailing out a bank or a financial institution is indeed lending a helping hand to it in monetary terms in order to sustain its downfall as that particular institution is no longer able to function properly. A bailout may take the form of cash, loans, stocks or bonds. It can be done just to earn profit and for improvement of a society, but bailing out financial institutions in an emergency is a dicey decision, and I feel that the governments should not bail out banks or private companies. Bailing out banks and other financial institutions, would only make them rely more on the government which would do nothing to improve the economy of the nation.

Bailing out banks in an emergency is absolutely no solution. Although, there are pros and cons to every discussion, but I feel that instead of focusing its attention on the failing institutions, the government should pay more heed to the poorer section of the society, as they are more likely to be affected when an economy dilapidates. It should provide financial assistance to them, instead of wasting liquidity on the already failed banks that too when the government is in deficit and does not have enough funds. The government, in such a situation should focus more on the people who are the backbone of any society. Failing banks should be allowed to fail, instead of the government going out of the way to provide for them. Only the strong deserve to survive. The very fact that the particular bank has reached the point of being bailed out reflects its weak working ways, mismanagement and that it cannot survive in a tough economy. New companies should be given a chance to prove themselves and be allowed to thrive.

Bailing out banks is wastage of funds on such financial institutions which should be allowed to fail. Only when space is created can other financial institutions come up. The government should abide by the concept of a free market in a capitalist economy. A free market is a market economy wherein the market functions according to the forces of demand and supply with little or no government intervention. It is a completely free economy in which buyers and sellers are allowed to carry on with their transactions freely without the intervention of the government in any form. They are allowed to work freely and independently. In a free market, individuals provide new ideas and views. Everyone tends to work hard and in turn their hard work is rewarded. A free market provides a variety of goods to consumers according to their changing demands and preferences. It also uses better and advanced means of production to produce goods and services.

Therefore bailing out of banks by the government in a free market would mean government intervention. It would only lead to a weaker economy because all the weak functioning banks would have been bailed out, creating no room for new and better banks to function. The aim of any government is to strengthen itself, not to accumulate weak functioning institutions. It is acceptable that the government wants to save the failing banks, but it should also be understood that this will only make them more dependent on the government in future. How can the government expect an economy to grow and thrive and to withstand any pressure on it , if the economy comprises weak functioning banks.

Everyone must learn to adjust and adapt to the change in order to make an economy strong. It should be accepted that the company or the bank may be having certain loopholes in its functioning which is posing a threat to the economy. It is alright to let it fail. Bailing them out will further weaken the economy and worsen the already bad conditions and it is the people who will have to face the repercussions in future.

Almost a trillion pounds were spent bailing out financial institutions in Britain in the 2007-2009 recession. This amount was more than that has ever been spent by the British government on any project in the history of Britain which resulted in Britain experiencing the worst recession ever. Almost all the 100 US banks which were bailed out failed to function in spite of getting bailout funds. Thus, the entire money which could have been spent for better purposes was wasted.

Malaysia too had to undergo financial crisis during the recent recession. Malaysia is a small and depends largely on exports. So \there could have been no way by which it could have been spared the effects of recession. Exports dilapidated and investments badly declined. There was a drop in the flow of funds into the Malaysian economy. Exports were also badly affected. After 1982, it was in January 2009, that Malaysia experienced, rather suffered an enormous drop in exports which was that of 28 percent. Employment was also badly affected. The export production to the US was cut down as the demand from the U S was reduced. As a result, they were unable to pay the employees as they used to, which resulted in people losing out on their jobs.

Bailing out banks has moral hazards as well. In the theory of economics, moral hazard means taking undue risks, because the party taking the risks does not have to bear the cost. It refers to a situation where in the way one party behaves may prove harmful to the other party after the completion of a transaction. One party may decide that how much has to be taken while the other party will have to bear the costs if things do not turn up as expected. Moral hazards pop up when one party is not ready to take responsibility for the way it performs, acts or behaves. It fails to perform well and acts carelessly, or not as carefully as it otherwise would have. It leaves the other party to take responsibility for its actions and bear the consequences as well. To under the phrase better, we must know where the phrase first came from. It was first used by the Insurance Industry because the industry believed that if they would protect the people or their clients from hazards like accidents or fire, it would only make the people or the clients behave in a riskier manner and they would cease to be careful and be more careless. Hence the term was coined. Moral hazards may occur in the following situations.

  • When the position of the manager is quite secure and he cannot be removed easily from his office.
  • When there is someone in a higher position to protect the manager.
  • When the firm is not affected by the failure of a project, even if the failure affects the division which managed it.
  • When the manager may easily blame someone subordinate to him, who is in fact innocent.
  • When there is no way to determine that who actually is accountable for the project given.
  • When the senior management makes its own decision without considering the medium term effects or the risks which the business may have to face.

Thus, moral hazards are a direct result of the bailout of banks and the discipline of the market is lost as these bailouts create more scope for financial crisis and also because the expectations of future bailouts are increased. This in turn, ruins the entire discipline of the market. Insurance expectation is also increased due to bank bailouts, which decreases the ability of the market participants to adjust to the risks which a bank may have to face. This creates a negative effect on the market, and weakens it. It also affects the efforts of the financial sector. These bailouts affect the risk taking ability of the banks to a very large extent. The bailed out banks end up taking more risk. Therefore the government should let them fail and as a result the bondholders and stockholders will not have money to invest in such institutions and eventually, such weak functioning institutions will no longer exist in the market.

The government keeps bailing out banks during periods of recession, which makes these banks and financial institutions think that they can rule the society as they are never allowed to fail and collapse. It seems that the banks own the government as it always rushes to their rescue. The government provides these banks with money which should instead, be used to eradicate larger problems in an economy which is suffering or undergoing recession.

Thus, bailing out banks is not a necessity. Instead, new and better financial institutions should be allowed to come up in order to create a better and a strong economy.

References


Bank Negara , Malaysia (2008) Annual Report 2008, Bank Negara Malaysia : Kuala Lumpur International Monetary Fund (2002) World Economic Outlook Washington DC International Monetary Fund

Lin , J.Y. (2008) The Impact of Financial Crisis on Developing Economies, Paper presented at Korea Development Institute , 2008

Shiller, R.J. (2008) The Subprime Solution: How today’s Global Financial Crisis Happened and What to do about it. Princeton University Press , Princeton and Oxford

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