Bailouts

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The global financial market has made headlines for the last five years due to the overwhelming amount of money that federal governments have had to dish out in order to make sure that major banks do not fail. In the United States alone, it is estimated that billions of dollars’ worth of taxpayer money went directly into saving banks that did not have enough cash to sustain its troubled assets. Couple this with the inherently risky behaviors that Wall Street has practiced with sub-prime mortgages and other derivatives, and the issue is compounded. Unfortunately, financial institutions play such an integral role in making sure that the economy stays afloat. If major banks were allowed to fail, then it could potentially mean a collapse of the currency that much of the world relies on. Large scale federal bailouts of banks that choose risky for-profit behavior represent a serious risk to the well-being of the overall economy and require careful use of government resources. 

The Nature of Bailouts

During the course of the 2008 financial crisis, the government found itself amidst a serious crisis that required it to intervene. Because of bad debt that could not be repaid through loans and investments, banks found themselves in a situation where they did not have enough cash assets in order to continue with normal business operations. This lack of liquidity forced the federal government to supply a cash infusion of funds so that the major ones could still operate without declaring bankruptcy. A major problem was that so many banks needed to be bailed out in 2008. Moreover, the government did not have a choice if it wanted to preserve the financial sector: “if our government was playing by the rules--which require shutting down banks with inadequate capital -- many, if not most, banks would go out of business.”1 Consequently, the Troubled Asset Relief Program (TARP) enabled the federal government to use taxpayer money in order to fund specific delinquent banks. 

In the case of major institutions like JP Morgan Chase, Bank of America, and Goldman Sachs Group, the federal government knew that their failure would result in a complete meltdown of the United States economy. The federal government thus has a major role in ensuring that it does what is necessary to keep major banks in business. However, the federal protection of major banks also means that there is less accountability for risky investments.2 As a result, banks like those take their livelihood for granted when it comes to leveraging their assets without insurance that they can sustain financial growth and prosperity. According to an interview of prominent politicians that worked on the TARP committee, they claimed that saving the major banks was an inevitable choice: “we had no choice. We had a gun pointed at our heads. Without the bailout, things would have been even worse.”3 Essentially, regulators felt as though they were positioned to approve the bailouts as a necessary precaution. Despite the fact that many banks made terrible business decisions and over-extended their assets, they were still eligible for protection.4 In this case, the federal government’s role was purely to protect the well-being of the overall economy, even if it meant utilizing taxpayer dollars to pay highly paid executives for making bad decisions. 

Should They Be Allowed to Fail?

The underlying premise of the American economy is that it works on the basis of competition and the risk of failure. If businesses fail and go bankrupt in other industries, the government is not likely to bail them out. However, the financial sector is a peculiar case because of its relative importance with respect to the entire United States economy. If banking centers closed and people lost their insured money then even more problems would arise. Ultimately, the major question to ask is if these institutions should be allowed to fail if they cannot manage to be self-sufficient. Federal regulators seem to think so, despite the fact that the process by which banks are allowed to fail is also unfair and induces risky behavior as well. 

Facts, Expert Opinions and Historical Precedents

While the total dollar amount is still debated, estimates claim that the bailout problem was much more serious than people could have ever imagined. Stiglitz remarked that baking infrastructure in the United States was operating with roughly two to three trillion dollars of bad debt that needed to be accounted for.5 This means that while some banks were saved, many others still declared bankruptcy and were either liquidated or acquired by a larger institution. The federal government has cited that their total TARP contributions to the banks were in the neighborhood of seven-hundred billion dollars for just the 2008 crisis.6 In the final outcome, only major banks survived and many investors, hedge funds and other organizations lost billions of dollars in the process. Again, the justification for these allowed failures was that a select few banks were essential to the financial infrastructure of the United States and things would have been worse if they had been allowed to fail. 

Banks engage in risky behaviors because Wall Street fosters a culture of profitability over principles, something that the SEC monitors closely. Public companies on Wall Street are always under intense pressure from investors and analysts to produce growth year over year and higher shareholder value. This has unfortunately resulted in a rat-race in which risky behavior is encouraged if it can yield highly profitable rewards.7 Take the example of Enron as a prime example of destructive and greedy behavior that fit the mold of the Wall Street culture. As Enron was hailed as one of the most lucrative and powerful energy-related companies in the world, Wall Street analysts and investors demanded higher and higher standards of profitability that resulted in bad business decisions: “in seeking to meet expectations it expanded into areas in which it had no specific assets, expertise or experience— including water, broadband, and even weather insurance.”8 While Enron was not lucky enough to be bailed out, its failure exemplified the Wall Street mentality that unethical and risky business practices will prevail. For the case of banks, the same is true with the exception that the bailout variable creates a moral hazard where no one has to be accountable for the lost money. 

Expert opinions also show that the way in which banks are bailed out can encourage risky investments and make the problem worse. For instance, Viral Acharya and Tanju Yorulmazer, both prominent banking figures, argued that the banking crisis was a zero-sum game where for some major banks to win, many smaller ones had to lose and get acquired.9 As smaller banks failed, larger ones knew that if they acquired their bad debt then they would have a greater chance of being eligible for a bailout. As a result, there may have been a positive feedback loop where larger banks were merely getting themselves in a deeper hole. 

As we have seen, banks that practice risky investment behaviors chose to pursue profit over sound business decisions. Unfortunately, this resulted in government bailouts that questioned the very essence of capitalism and being allowed to fail. The federal government spent nearly one trillion dollars to bail out institutions like Bank of America and Goldman Sachs Group in order to preserve the financial institutions that the United States economy depended on. Their risky investment behaviors also fell in line with Wall Street mentalities that pursuing profit and exceeding expectations was the norm. This may have led to a positive feedback loop where failing banks felt pressured to acquire smaller ones (and their debt) in order to secure funds, resulting in a moral hazard.

Notes

1. Joseph Stiglitz, “A Bank Bailout That Works,” The Nation (New York City), March 4, 2009, http://www.thenation.com/doc/20090323/stiglitz/print (accessed January 25, 2013).

2. Viral Acharya and Tanju Yorulmazer, “Cash-in-the-Market Pricing and Optimal Bank Bailout Policy,” Review of Financial Studies 21, no. 6 (2008): 2707.

3. Stiglitz, “A Bank Bailout That Works,” 3.

4. “The true cost of the bank bailout | Need to Know” PBS: Public Broadcasting Service, 2010, http://www.pbs.org/wnet/need-to-know/economy/the-true-cost-of-the-bank-bailout/3309/ (accessed January 26, 2013).

5. Stiglitz, “A Bank Bailout That Works,” 

6. Stiglitz 

7. Joseph Fuller and Michael Jensen, “Just Say No To Wall Street,” Monitor Company and M.C. Jensen February (2002): 5.

8. Fuller and Jensen, “Just Say No To Wall Street,” 5

9. Acharya and Yorulmazer, “Cash-in-the-Market Pricing and Optimal Bank Bailout Policy,”

Bibliography

Acharya, Viral, and Tanju Yorulmazer. "Cash-in-the-Market Pricing and Optimal Bank Bailout Policy." Review of Financial Studies 21, no. 6 (2008): 2705-2742.

Fuller, Joseph, and Michael Jensen. "Just Say No To Wall Street." Monitor Company and M. C. Jensen February (2002): 1-8.

Stiglitz, Joseph. "A Bank Bailout That Works." The Nation (New York City), March 4, 2009. http://www.thenation.com/doc/20090323/stiglitz/print (accessed January 25, 2013).

"The true cost of the bank bailout | Need to Know" PBS: Public Broadcasting Service, 2010, http://www.pbs.org/wnet/need-to-know/economy/the-true-cost-of-the-bank-bailout/3309/ (accessed January 26, 2013).