Long live the taxpayer: Big banks don't fail and that is by design

It is standard practice in all countries and its origins lie in the creation of the US Fed in 1915

Here’s a question that is troubling many people in the wake of the YES Bank collapse: If the stability of the financial system wobbles because one bank screws up, why should taxpayers save the shareholders?

Good question because this has become the standard practice in all countries. It’s grossly unfair but many think it’s justified even though it results in what economics calls ‘moral hazard’.

The concept refers to a situation where insurance increases the propensity of the insured to take higher risks because someone else bears the cost of those risks. This also renders meaningless the traditional warning of caveat emptor (buyer beware). Yet we go on forcing taxpayers to bail banks out.

This idea, which is now accepted uncritically globally, has its roots in the big financial crisis of 1907. It was then that J P Morgan started the idea that banks are special and needed to be treated differently. He put forth the proposition of a ‘bank of last resort’ and was chiefly instrumental in creating the US Fed. Its job was to save the shareholders of US banks. But its main aim was stated to protect farmers! The story is worth retelling.

A financial crisis had been building up from 1905 onwards. It was the usual ‘exuberance’ story and in 1907, a financial firm with the strange name of Knickerbocker Trust Company went under. Several others also went bust at the same time and a major crisis developed. But there was no ‘lender of last resort’. Not only that: these firms were all stitched together in complex web of interlocking directorships, loans, and collateral bonds.

Photo: Dalip Kumar

So several of the moneymen went to J P Morgan and they all sat down to solve the problem. They decided that those who could not pay their debts had to be given money because if they did not all hang together, they would all hang separately.

The treasury secretary was willing to allow the use of government funds but nothing came of it because of political opposition.

However a consensus had developed that the time had come to set up an equivalent of the Bank of England. The clamour for a lender of last resort grew and the US Congress, pushed by its backers, constituted a National Monetary Commission. It was probably discreetly told what ideas would be acceptable.

In November 1910, they all met under the pretext of a duck shoot in an island appropriately called Jekyll Island. There they discussed how to avoid future financial panics. They recommended that the Fed be set up, which happened in 1913.

It was almost an exact copy of the Bank of England. The 12 regional banks and the Fed would make up the regulatory system which started working in 1915. The Fed was put in charge of currency and it alone would decide how much to print and when. Its main job was to control interest rates via the sale and purchase of government bonds. But it also became the lender of last resort because it could print as many notes as seemed necessary.

Since 1930 central banks  have banded together in a very private club in Basel, Switzerland. The club is called the Bank of International Settlements (BIS).

Its website says “The mission of the BIS is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.” The BIS specifies the amount of capital a bank must have to ensure it has enough capital to absorb unexpected losses.
 

Now big banks don’t fail. They are either bailed out with large dollops of cash or merged with healthy banks. The last big bank to fail in the world was the Manufactures Hanover Bank in 1974. In India the last big bank to fail was the Palai Bank in 1961.

Since then the taxpayers have been paying to save banks.

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