Necessity of Bank Bailouts - Essay Example

Capitalism tends towards the idea that organizations are in good luck when they make significant profits but it's tough luck when they make significant losses, getting neither sympathy nor envy. However, the economy today is not a pure free market but, rather, it is a mixed economy, in which the markets are regulated by a government instituted framework. In addition, the government also carries out various functions, instead of leaving the private sector to make decisions (Mitchell, 2014: p61). The banking sector is a prime example because of its importance to the economy, including the management of loans and savings facilities.

The banking crisis of 2007 initially led to a rush by UK citizens to withdraw their money all at once, meaning that banks would have failed since they would have been unable to pay, portending potentially incalculable damage to the UK economy. It was, therefore, the responsibility of government agencies to stabilize the system by supervising banking activities and propping up banks that threatened to destabilize the system through bailouts (Cordella & Levy-Yeyati, 2013: p34). In essence, it is the people owed money by the banks that the government is bailing out. In addition, some of the biggest investment banks in the world are institutions that are so critical to the market and job creation that they have gradually come under the control of the government.

This explains the bailout of AIG by the US government with a $100 billion loan that ensured American businesses would not collapse if they suffered losses, hurting national employment levels. The takeover of big mortgage guarantors in the UK, such as Bradford and Bingley, was also necessary because, in spite of its private shareholding, it was a de facto agency of the government and, in effect, the public (Cordella & Levy-Yeyati, 2013: p35). Failing to nationalize the company would have devastated millions of ordinary UK citizens who were homebuyers.

However, not all banking institutions were rescued, the London Scottish Bank and the Dunfermline Building Society were allowed to fail because it was possible to do so without much income flow-on damage to households and other financial institutions. Within the short time financial markets, banks borrow money from other banks if they are low on exchange settlement funds, especially from banks that have more funds than required (Eijffinger & Nijskens, 2012: p43). The Bank of England controls the cash rate, which happens to be the charged interest rate for these borrowings. The banking crisis resulted in banks tending to be reluctant in lending funds to other banks, which necessitated the intervention of the Bank of England in lending to banks that are short on funds.

Failure to do the aforementioned would have resulted in a shortage of exchange settlement funds, leading to a great increase in official interest rates; more than recommended by the Bank of England. In this case, the institution is manipulating the exchange settlements fund supply and demand balance, as it always does, maintaining the cash rate at its preferred level (Eijffinger & Nijskens, 2012: p43). When the markets stabilize, the Bank of England will institute policies to reduce the extra liquidity, meaning there will be little impact on long-term inflation. Read More