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Economics: Should Gov't Bail Out Failing Banks?


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About this Lesson

  • Type: Video Tutorial
  • Length: 8:36
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 92 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Banking, Spending, Saving and Investing (19 lessons, $30.69)
Economics: Financial Markets (4 lessons, $8.91)

This economics video lesson asks: : Should the U.S. Government bail out failing financial institutions? Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Suppose you have a really amazing auto insurance policy. Anytime you have any problem with your car you can take it directly to the body shop or the auto mechanic, and your insurance company will pay for everything and not ask any questions. If you had this much insurance, chances are it would change your behavior, you might start to drive a little more carelessly or not be so diligent about parking your car in safe places. That's because, since the insurance company's bearing all the risk, you're inclined to take more risk. This phenomenon is called "moral hazard." Whenever you are able to pass the risk on to someone else, you'll take actions that increase the risks and the costs for your insurer. That's why your insurance company will give you a deductible; you have to bear some of the risk so you'll be careful, or the insurance company will only insure a fraction of the risk, leaving some of it with you. Or perhaps, they're going to monitor your behavior to make sure you that don't behave in careless ways. This is the way insurance companies solve the problem of moral hazard.
Now that you understand moral hazard, you're able to think about what caused the banking crises of the 1980's in the United States, because banks were in a similar position. Start with thinking about the depositors. Because depositors have insurance through the Federal Deposit Insurance Corporation, we don't worry what banks are doing with our money, because if you have trouble getting your money out of the bank, the Government will simply bail you out with money from the insurance fund. Therefore, depositors don't pay a lot of attention to what their banks are up to.
Next, think about the banks themselves, the owners of the have subscribed capital to the bank. That is, they put some of their own money at risk. If the bank invests in risky projects, and makes a huge windfall, jackpot profit, they get to keep it all. On the other hand, if the bank goes bust because of risky loans, all they lose is the capital they subscribed. Their up side is potential unlimited and their downside is strictly limited. Therefore, banks face a kind of moral hazard; they're inclined to take risk, because their depositors don't care because they're insured and the banks have only a limited amount of capital at stake.
Now, this lets you know what's going on in the 1980's when we start to look at the banking situation. Consider what's happening in the years leading up to the 1980's. Suddenly there are all kinds of financial innovation giving small savers options for where to put their money. Before, they had to put it in the bank or else not earn interest; but now you've got suddenly money market mutual funds popping up and other opportunities for small savers to invest their money and earn market interest rates. In order to be competitive now, banks have to pay higher interest rates to attract savers; and earning higher interest rates means investing in riskier projects that pay those higher interest rates. So before, banks invested pretty much just in small business loans, but they understood, or mortgages, or household loans. But, in the 1980's banks, due to a change in law enacted by Congress, suddenly had latitude to invest in a wide array risky projects, including commercial real estate ventures, and commercial paper of companies, and so forth. All kinds of things, eventually investing even junk bonds. Banks had to do this or they couldn't earn the market interest rates that allowed them to compete with other options that were available to small savers.
Banks were quickly getting in over their head investing in risky projects that they didn't really understand that well. They didn't even know how to calculate the risks because they had no experience. Then when the economy slipped into recession in the mid-1980's, what happened was, a lot of these loans suddenly became non-performing. The businesses that the banks invested in, the people that the banks had lent to, were unable to repay the loans and suddenly the banks found themselves with their assets evaporating overnight, losing value. But they still had liabilities, they still owed their depositors money and that meant, in many cases, the Federal Deposit Insurance Corporation had to step in, take control of the bank, and bail it out. That is, it had to make good on the commitment to the depositors out of the government's insurance funds.
Now, from 1930's whenever bank deposit insurance was first created by congress as a response to bank runs during the Depression, and the 1980's; typically anywhere between two and six banks would fail in a typical year, and it was usually a very unusual event. However, in the 1980's, between 1980, itself and 1994, about 1,600 commercial banks of the United States failed. That is, they became insolvent, they didn't have enough assets to make good on their liabilities and the FDIC had to step in and bail out the bank, and make good on their commitments out of the insurance fund.
Now, ultimately, we taxpayers are responsible for replenishing that insurance fund; ultimately it's us taxpayer that are left holding the bag when a bank fails and has made a bunch of bad loans and still has accepted depositors money that has to be paid off. So, we taxpayers may have a concern, why is it we are insuring the banking system; why is that we are creating a set of incentives that tempt banks to create relatively risky loans?
Well, let's think about it, one option would be to abolish deposit insurance all together, let's don't even have it. But then, you're back in the situation we faced in the depression, which is, when one bank fails, everyone gets spooked that maybe his or her bank is going to be next. So runs on one bank; lead to banking failure; lead people to go to another bank; try to take their money out; create a run on that bank; and perhaps push that bank into a liquidity crises, or into insolvency. This is the problem with the psychology of banking, people think that the banking system is so tightly interconnected, that it's very easy for failure of one bank to spread to another and another, through a kind of psychological contagion and hysteria. So, deposit insurance stops that chain of dominos from falling. What about private-deposit insurance so that the taxpayers aren't responsible? Well, that's a great idea; but you know, there isn't any financial institution anywhere in the world with enough money to stand behind the United States banking system. The liabilities are just way too large, ultimately the government has to be behind it or the system won't be credible.
Okay, then what about some of the fixes that my insurance company tries with my auto policy? What about deductibles, partial insurance and monitoring? Well, all of these things are now becoming more and more part of the way in which bank deposit insurance works. As far as deductibles are concerned, we can enact a policy that increases the amount of money that banks have at stake. That is how much they have to lose in the even of a bank failure. And these are the so-called "capital adequacy requirements." Increase the amount of capital that the bank owners have to put at risk, so that they are less inclined to take extraordinary risks and threaten the Deposit Insurance Fund and pass the bag onto taxpayers.
A second policy is risk-rated insurance. That is, banks that are making riskier loans have to pay higher insurance rates, kind of like smokers have to pay higher health insurance rates, or you have to pay a higher auto insurance rate if you drive certain kinds of jazzy sports cars. A final policy involves monitoring. And that is, when auditors come into that bank, and make sure that banks are obeying all the rules for good standards and practices. That is, that the banks aren't investing in loans that are regarded extraordinarily risky, and that in fact, they are running a tight ship. And that if the banks don't measure up in these audits, that they are fined or their insurance can be taken away, or they can be even closed down.
So there you have it. The way to solve the problem of moral hazard that's created inherently when you're insured, is to do things that pass some of the risk back to the person who's insured, through deductibles, through risk-rated insurance policies, and through careful monitoring to make sure that good behavior is enforced. So, maybe the government does have to have a role in deposit insurance. But if they do, they have to think carefully about the way in which deposit insurance changes the incentives of the banks involved. Otherwise, we wind up with that situation in the 1980's, where every time you drove by a bank, it seemed like it had a different name on it, because banks were behaving in such a risky way that they were failing, being bailed out, being bought out, and being renamed almost as fast as the identity had previously changed. What we want is banks that are stable, that have an incentive to invest in good productive projects and the right kind of deposit insurance scheme can give us the benefits of a stable banking system as well as proper insurance for proper incentives for good bank behavior.
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