Why do Banks Get Bailed Out?

Readers Question: Why is it okay for Curtis Mathes Corporation to go belly up, but not an airlines, or a car company, or a bank?

It is an interesting question.
- Why does the government rush to rescue those companies who caused the current financial crisis through their own bad management?

Curtis Mathes is an electronic company. At their peak they had 3,500 employees. If a company like this goes bankrupt, it has no macro economic effect. In other words, the bankruptcy causes pain to individuals, but, doesn't really affect the wider economy.

In the case of a bank there are very good reasons to prevent, even one bank, from going bankrupt. The problem is that if one bank goes under, people lose confidence in the banking system. You would see savers queueing up to take out their deposits. But, the banks would not have enough cash to meet the avalanche of deposits. Banks only keep a small % of their reserves in cash - about 1%. This is because it is more profitable to lend out money - on which they can earn interest rather than keep it in a big safe. Banks rely on the fact most people do not suddenly demand all their deposits. But, if confidence in the banking system collapsed, people would want to withdraw. Just last year, the UK saw queues of savers trying to get their money out of Northern Rock (even though there was little necessity to do so). Eventually the government had to guarantee all the savings.

In a previous post, a reader asked - what would happen if all the customers required their deposits? - Banking collapse and the withdrawal of money

Note: In the Great Depression of the early 1930s, many medium sized banks did go bankrupt because there was no mechanism in place to secure all their funds.

What Would Happen if Freddie Mac and Fannie Mae went Bankrupt?

The main thing is that it would be very difficult for American banks to finance any new mortgages, especially in the current climate. Banks would struggle to raise the finance for lending, so would rely on their own saving deposits which would be insufficient.
The banks would have to increase the cost of mortgages and also require much bigger deposits.
This would cause a further fall in demand for houses and further price falls. This would exacerbate the economic slowdown and cause a more serious recession.

Should Governments Rescue National Airlines?

This is a disputed point. I think governments often rescue national airlines out of a sense of national pride (Swiss Air springs to mind). They are big employers, but, they don't have the macro economic impact that banks do.
Perma Link | By: T Pettinger | Tuesday, September 9, 2008
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