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So why the hell do we bail banks out?

It's capitalism, stupid! You screw up then you lose everything

Big, busty b*nkers

So, why didn't we let HBOS (and it was HBOS, Lloyds got screwed by taking it on) or RBS (or BoA, Chase etc) go the same way? Which brings us to our second reason for bailouts.

Because these banks are systemically important. Another way of saying the same thing is that they're too big. If they fall over then we'll just have some smoking rubble where we thought we had a financial system: and or an economy. By analogy if 50 companies scrap over the food market then we can allow any one or a few of them to go bust. If one firm has 100 per cent of the food market then we can't let it go bust: we'd all starve.

If RBS went over, properly and entirely into bankruptcy, bankers shoved out the door with a cardboard box containing their potted fern, then ATM machines would start to go empty as everyone and their grandmother tried to flee into cash. And they would do it at every bank: and we're in a fractional reserve system recall. No bank, even the best, can repay everyone immediately.

So, these systemically important banks are also known as “too big to fail”. It's not that they can't fail, Sir Fred Goodwin showed that, it's that we cannot allow them to. And that's our second reason for bailing out banks. When one does become insolvent (as RBS almost certainly was) we still can't let it fall over. We've got to stick some capital into it and try to sort it out.

Please note that this is not a good reason for such bailouts. That this situation was allowed to develop is instead a bad reason for such necessary bailouts. But given where we were/are it's a truly great reason.

There are answers to this. And amazing as it may seem, the politicians have managed to rather grasp this. The first stage is to make those large banks safer. To insist that they have larger fractional reserves, that they've got more capital to cover losses that might make them insolvent. This is being done and successfully too. Leverage (the multiple of capital that banks can borrow short and lend long on) has fallen considerably. There's also a number of hybrid capital structures ... but nah, you don't want that level of detail. We're also trying to make those large banks smaller.

Which brings us to a part of the response to the crash that I rather admire: the bank levy.

Viewed the other way around, being a too big to fail bank is a subsidy. Because people know you can't fail, you'll always be bailed out, so they will lend to you at lower rates than they would a smaller bank. So you, just by being a large bank, can make a higher profit margin. This isn't, to put it mildly, what we want to happen.

So, (and both Blighty's Chancellor of the Exchequer George Osborne and U.S. President Barak Obama got this right) charge those large banks a fee for that insurance they're getting. This will a) remove that advantage; b) make them cough up for their privilege and c) encourage them to become smaller. And they are becoming smaller.

Here in the UK, there are those who predict that in another five years we won't really have any banks that still qualify as too big to fail (note that this is about domestic retail banking, not the City at all. One of the great American bank runs was Continental Illinois and they were a purely wholesale bank and the general public just didn't even notice).

With the requirements for greater capital, less leverage, we've made the runs less likely in the first place. As up at the top we've no problem with the central bank financing solvent but illiquid banks. And if we can get all of the banking networks down below that TBTF level then we're pretty much done.

We'll be left with the liquidity support, which we think is a fair price for the benefits of maturity transformation and we'll not have to bail out (although we'd still have to manage into the grave) insolvent ones. Which is really rather where we want to be.

Please do note this final point, though. This is not a perfect banking system.

It is entirely possible to take a different view (for example, by putting less weight on the value of maturity transformation). But this is roughly the consensus these days. On balance, we know we've got an inherently unstable system but it's worth it. But those who truly fuck up should go spectacularly bust. We need to – and we are doing so – massage the system to the point where that is possible.

Central bank liquidity provision, more capital, the bank levy and shrink the too big to fail banks to where we can let them go pop. Not a terribly exciting answer to be sure, but probably the right one. ®

Want to hear more from Tim in person, or to tell him why he’s wrong, face-to-face? Come and hear Tim at the Reg’s Summer Lecture season as he explains the absurd economics underlying the technology industry by taking us on a journey around the world’s rare metal’s hotspots. Full details here.

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