Should a country always stand behind its banks?

December 7, 2010

Ever since the financial crisis broke in 2008 some of the world’s major banks have their governments to thank for their survival. The fates of Royal Bank of Scotland or Citibank would have been much worse without large injections of capital from the UK and U.S. authorities. The UK government pumped more than £37 billion into its largest banks in the immediate aftermath of the Lehman Brothers crisis. Ireland took that a step further when it guaranteed all of its banks’ deposits and liabilities. This was affordable, the Irish government said at the time.

However, this policy failed spectacularly. Ireland’s bailout of its banking sector brought the country to the edge of bankruptcy and forced it to accept a 82 billion euro bailout loan from the IMF/ECB and the European Union. More than 30 billion euros of this loan is to re-capitalise the Irish banking sector and the rest is to shore up the state’s finances. The conditions of the loan mean that Ireland will have to implement harsh austerity measures for many years to come that will inevitably hurt growth.

So should governments always stand behind their banks? There are some success stories. Back in 2008, when the global financial sector teetered on the brink of collapse, it was necessary for the world’s major central banks and governments to offer unlimited support to their banks. The chief reason for this was to ensure that credit flowed through the economy to foster growth. In truth however, a mixture of stringent capital rules caused banks to shrink their balance sheets in the teeth of the recession, which didn’t help the overall economy but did boost their balance sheets. In the first six months of 2010 the UK’s four largest banks: Lloyds Banking Group, Royal Bank of Scotland, Barclays and HSBC (the latter two did not receive bailouts) made combined profits of £13.6 billion. This is a far cry from the £22.3 billion they lost in 2008.

The U.S. banking sector has also seen earnings recover sharply. The Federal Deposit Insurance Corporation (FDIC) announced that the earnings for U.S. banks rose by $14.5 billio in the third quarter of 2010. Now that the banking sector is back on its feet again one can hope that credit conditions will also become more supportive of economic growth. And strong earnings also increase the chances that taxpayers will profit from the capital injections at some point.

So why did things go so wrong for the Irish? There are two reasons. Firstly, the government’s guarantee to cover banks liabilities was too hasty. It didn’t inject capital, instead it promised to write an unlimited number of blank cheques. Secondly, there was a mis-match between the size of the banks’ liabilities and the size of the state. Ireland’s economy was 210 billion euros in 2008, the cost to bailout Anglo Irish Bank alone is at least 30 billion euros, and by some estimates it could be 50 billion. This makes the $40 billion plu capital injection (which then turned into equity) into Citibank look like small change for a $14 trillion economy like the U.S.

The trick is for governments not to bite off more than they can chew, and make sure they have conducted a rigorous analysis of a bank’ liabilities before underwriting its future losses. If you don’t do this then the punishment can be harsh, as Ireland has found out.

On paper Ireland’s banks guarantee doesn’t look like such a good idea, but a bank is also part of a country’s social fabric. Its citizens trust the banks to look after their deposits and expect 24-hour access to their money to fund their living costs – paying for a mortgages, school fees, clothing and food. If customers can’t access their money this hits confidence in the central plank of capitalism – the banks. The US has the FDIC to protect deposits of up to $250,000; Ireland didn’t have an equivalent institution so in October 2008 it had to offer a government guarantee for deposits. This was the right thing to do; however, it should have stopped there. A government should protect the hard-earned savings of its citizens, but it is learning how expensive it can be to essentially take on the risk for banks’ bondholders as well.

The Irish crisis may have been avoided if the government hadn’t been so generous with its guarantee. This could have limited the fallout from the sovereign debt crisis that is now threatening the very existence of the euro zone project and the single currency.

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