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Why is it that banks have not been allowed to fail? One factor is precedent: by not letting banks fail, expectations of a similar response in the future have been built into the system. This has triggered a self-fulfilling circle. Time inconsistency also plays a role: the rewards from letting banks fail – reducing moral hazard and the risk of the situation repeating itself – are long-term, whereas the costs – in the form of financial destabilisation and voter outrage – are likely to be felt imminently...
A number of points that I think are fundamental deserve highlighting:
Firstly, management of bank failures must be as predictable as possible. One cannot alter the rules of the game without adequate prior notice: if that happens, even the most well-considered and justified line of action will be detrimental to market and depositor confidence.
Secondly, the bail-in tool is complex to use. It has many benefits, not least in terms of its pre-emptive effects and the risk awareness it will create. However, risks of contagion could cause worse problems than those which initially triggered the action, especially in banks whose only creditors are depositors.
And thirdly, bail-in is unlikely to be sufficient in crises of systemic proportions. When the very infrastructure of our economies, such as the system of payment, is in peril, the government has a responsibility to act: assuming ownership provides taxpayers with the best chance of getting their money back.
By not allowing for government intervention as a last resort, future bank rescues will be more or less solely dependent on bail-in. In a systemic crisis, this might cause more problems than it solves and thus reduce the possibility of bail-in being used at all. If markets know governments may intervene, bail-in will be more credible. Thus rescuing banks can produce both a reduction of moral hazard in the banking system and an enhancement of its systemic stability.
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