Why bank bailouts may be making the financial system more fragile
Morningstar's James Gruber says the bailouts of SVB and Credit Suisse have received little pushback, yet they should as they make another financial crisis more likely.
Opinion: Bank bailouts get little pushback these days. In 2008, the bailout of the ‘too-big-to-fail’ financial institutions led to the Occupy Wall Street and Tea Party movements in the US. This time, there’s been barely a peep.
Silicon Valley Bank was a midsize bank with US$175 billion in deposits and 17 branches in California and Massachusetts. The bailout involved a guarantee for uninsured deposits of more than US$250,000, thereby getting rid of the limit on deposit insurance. There was also the introduction of a new Bank Term Funding Program (BTFP) that gives banks access to liquidity from the US Federal Reserve to meet deposit outflows by borrowing against their own long-term securities (which effectively act as collateral).
In the case of Credit Suisse, the bank had a decade-long series of scandals and mismanagement and as deposits rushed for the exit door, the Swiss central bank had to step in with a US$54 billion loan. That didn’t work and eventually bank rival UBS bought Credit Suisse for next to nothing with government guarantees to protect any downside from the deal.
I’m going to argue that both bank bailouts were unnecessary and they make another financial crisis more likely.
The politics of bailouts
There’s often an emotive tone to bailout debates. Opinions tend to be divided along economic and political lines. For instance, economic free marketers argue that bailouts should never happen. They say capitalism works because of business failure or creative destruction.
Businesses failing allows poorly managed assets to be sold at bargain prices to other firms that can develop them more effectively. It allows economies to grow faster through the removal of bad business ideas and investments. It’s funny that Silicon Valley epitomised this capitalist streak with its ruthless approach to failed concepts, yet it ended up pleading for a bailout of SVB anyway.
On the other extreme are neo-Keynesians who argue that bailouts are necessary to maintain or save the financial system. They believe that ordinary people’s deposits shouldn’t be foregone because of the silly decisions of a bank. And that central banks were set up for this precise purpose – to be a banker of last resort.
These economic views are often political ideologies in disguise. Economic free marketers are mostly on the right-wing of politics, while neo-Keynesians are principally left-wing supporters.
I’m somewhere in the middle of these extremes, believing that bailouts should only be used when the financial system is in danger of collapse, like it was in 2008.
Bailouts are becoming de rigueur
No matter what your ideology, three things are becoming increasingly clear:
1. Financial crises are becoming more frequent
Deutsche Bank did a 2017 study of developed markets using the following criteria to define a financial crisis: on a year-on-year basis, a 15% fall in stock markets, 10% decline in foreign-exchange, 10% increase in inflation, 10% fall in bonds, or a sovereign default.
It found occurrences of financial crises had increased from the early 20th century and had accelerated from the 1970s.
Source: Deutsche Bank
2. Bank bailouts are also happening more often
We’re not only getting more financial crises but more bank bailouts also. Historian Niall Ferguson has found that central banks have expanded their balance sheets to calm financial markets in more than 50% of the crises since World War Two.
3. Yet the interventions don’t seem to be helping economies
Economic productivity in most developed markets, including Australia, has declined in recent years.
In the US, so-called total factor productivity growth has been 0.5% since 2008, after averaging 2% from 1870 to the early 1970s. In Australia, it’s a similar story.
Source: Parliament of Australia
Why are there more financial crises?
Before I get to why bailouts have become de rigueur, let’s first address why there have been more instances of financial crises over the past 50 years.
I think one reason is due to the breakdown of the Bretton Woods economic system. This system was established in 1945 to fix exchange rates and essentially link them to the price of gold. Bretton Woods collapsed when the US broke the dollar’s peg to gold in the early 1970s. The link helped limit the amount of debt that could be created by governments.
Since that time, governments have been willing to spend more than they tax, thereby creating larger budget deficits, as can be seen with the US below.
The government spending spree has been helped by compliant central banks who’ve been willing to print extra currency to fund the budget deficits. As the charts below show, key central bank assets ballooned more than 6x from 2008 to 2022.
Normally, printing currency to such a degree would induce inflation. But central banks have got lucky with demographics and technology suppressing inflation enough to offset the printed currency. Until now, that is.
Another cause for financial crises happening more frequently is reduced bank regulation since the 1980s. Around 40 years ago, bank regulations were loosened as Reaganism and Thatcherite economics spread through the Western world. That culminated in the loose lending and fraudulent activity of banks which led to the 2008 crisis. After the GFC, regulations were tightened again via the Dodd Frank Act. The regulations included banks holding more capital, greater liquidity, and less leverage.
Yet the increased bank supervision may have come too late given the current fragility of the financial system.
Why are there more bailouts?
The popularity of bank bailouts as a response to financial crises isn’t difficult to understand. Without limits to budget deficits, governments think they can spend money at will, with seemingly few negative effects.
And bailouts are certainly popular with politicians. They get to save their constituents with the help of the central bank printing press. What’s the downside for these politicians?
The downsides to bailouts
Yet there are downsides to bailouts, though they are often not immediately apparent (which is part of the reason they are so popular with politicians):
- The world is now more indebted than it’s ever been.
Debt makes the financial system more vulnerable to unusual events like viruses and to more common ones like banking collapses. - Spending money recklessly has consequences.
Especially when it’s funded via printed money. Though inflation took a long time to rear its head, it’s now going to be hard to remove. - Bailing out bad businesses is bad business.
Free marketers have a point when they say that capitalism thrives on bad businesses dying and good ones thriving. Allowing bad businesses to survive sucks money away from the good businesses. This inevitably reduces economic growth. - Bailouts can have unintended consequences.
In the case of SVB and Credit Suisse, it’s likely to mean depositors will switch money from smaller banks into larger ones. That will result in a greater concentration of deposits in fewer banks. Concentration such as this invariably makes the financial system more dependent on these larger banks and therefore more brittle.
IF SVB and Credit Suisse were allowed to fail, it wouldn’t have endangered the financial system. The government and central bank bailouts have made us all worse off.