The greater the size of the bank, the greater the impact since larger values and more number of people get affected. In the limit, the risk of failure of large banks becomes systematic risk which everyone has to share.
Banks are interconnected, with large ones having their tentacles in every piece of the economy, real or financial. Not only are they lenders to every sector in the economy, but also financial intermediaries. This means they transform one type of security into another which atomistic investors like us hold as a financial asset. Thus, when banks fail two things happen. People credit lines go dry and the value of the financial assets we hold plummets.
The greater the size of the bank, the greater the impact since larger values and more number of people get affected. In the limit, the risk of failure of large banks becomes systematic risk which everyone has to share. This rationale for bailing out banks is labeled the “too big to fail” argument. Thus when banks become so big that the entire financial system gets threatened by their collapse, we as tax payers have to bear our share of the cost, i.e., the systematic risk.
The rush on part of governments to “bail” banks out after a spate of recent bank failures in Europe and North America (especially the US) makes one wonder what happened to these model societies of capitalism. USA was mockingly referred to as United Socialist Republic of America when the US Treasury Secretary Paulson first proposed the bailout plan for banks on September 20, 2008.
The irony is not lost since “markets-know-best” proponents of capitalism in the west not only permit efficient firms to keep the entire surplus but also conclude (unanimously) - let the inefficient firms fail. The intention is that tax-payers should not have to bear a cost to save them. Then why not let banks fail? It is not just the US which has resorted to bailing out banks. Europe, as a whole, had decided to inject its banks with over $2 trillion by middle of October 2008. On the other hand, China announced in November of 2008 a $586 bn fiscal stimulus package, though not a bank bailout.
Although the financial system needs such treatment, long-term state ownership of the banking system is an unattractive prospect. Academics have found a wealth of evidence that state-controlled banks can become politicised and misallocate capital. Paola Sapienza, of Northwestern University, found that Italian state-owned banks directed cheap credit to companies in regions which voted for their political patrons.
A decade after Japan’s financial crash, up to a third of firms were “zombies” kept alive through uncommercial lending by banks under government pressure. From Italy to Japan to China there is a host of evidence that state-controlled banks come under pressure to direct loans to favored constituencies and to keep uncompetitive companies alive with subsidized credit.
N Janardhan Rao, Lead Economist