Why the bailout is not a pro-market policy

Bail out. Example of public intervention

Bail out. Example of public intervention

Over the past few months and years, we all have heard others saying “We won’t pay your crisis” or “Rescue families, not banks!” on multiple occasions. The underlying idea in both cases is that people oppose commercial bank bailouts. Such bailouts, moreover, are often associated with libertarian or pro-market policies, but, we must question if bailouts are free market or interventionist measures. Do they correspond to State policies or market policies? If it splits out the bankruptcy cost among all citizens (socializing losses), then should we understand that it is a pro-market policy instead of being interventionist?

Since 2008 there have been numerous bank failures. We have often heard that those banks were “Too Big to Fail,” which means public funds are given to the banks to support them and avoid a financial meltdown. Strangely, this economic policy has been described in an unspecified way as “pro-market” or “capitalist“. Such reasoning can only be understood by making an extremely simple association of ideas: <<if States borrow money to bail out the banks, and bank owners are “rich“, then, states are bailing out “the rich” and “It is obvious that the rich represents capitalism”>>. The line of reasoning is as simple as wrong: capitalism is a system of ensuring the economic freedom of all individuals (by avoiding the State intervention), not a privilege a few businessmen benefit from.

In addition, we must make the following clarification: rescuing commercial banks with public money implies that taxes are financing the survival of the entities, and such public bailout means “socializing” losses among all the population; such a socialization works in the same way than on public pensions or public health services. This is to socialize the cost of such services among all citizens to make it accessible to lower income households. In regard to bank bailouts, it is exactly the same. This means, the cost of losses is shared out among the society, so  those directly affected (shareholders and creditors) do not assume the cost of the bankruptcy. Therefore, we must conclude that the bailout is an interventionist solution, and not pro-market.

Financing a bailout

Financing the bailout

In line with this, at capitalism the principle of responsibility is essential, that is, who makes a rewarding and satisfying activity for society receives yields in return for their good business (profit). However, the opposite principle also applies, i.e., whoever grows a bad business indefinitely ends up being punished by the market (bankruptcy). Therefore, it does not seem consistent with the principles of capitalism that a nefarious bank management is rewarded by the State by transferring the cost of bankruptcy to taxpayers, rather than assigning it to who has mismanaged the entity, or who has made a risky investment in a company ran by very unable or inept managers.

That is why the pro-market solution to bank failure is not a state bailout, but a private rescue (so-called bail-in), which consists of making the cost of the bankruptcy as the responsibility of the owners and lenders of that particular business.  How is this done? It is simple: Bankruptcy is defined as a situation in which a company is unable to meet its liabilities with the assets it has in its worth. Suppose losses have eaten all of the company’s net worth and its liabilities exceed its assets. In this case, the private solution would be: first, the shareholders lose all the value of their shares (their value is 0 €); second, if not sufficient, subordinated creditors (those who took higher risk) assume a release of their credit, so they would replace its subordinated debt for newly issued shares; third, if this is not enough, the senior debtors would be who would assume the cost, again by substituting debt for newly issued shares; finally, the depositors would pay the cost. However, it does not seem reasonable that someone who is not intended to make a risky investment assumes the consequences (the purpose of the deposit contract is not to invest). Either way, it could still remain possible that the interests of such deposits could be delivered to the depositors through shares, rather than cash.

In conclusion, in case of applying a bail-in, a full recapitalisation of the financial system could be done without spending a single euro of public money, and also it would transfer responsibility to who is really responsible. This solution would generate a very beneficial incentive in the financial system: the certainty that the cost of poor management is assumed by those who are responsible, and it will not be transferred to taxpayers through interventionist policies.

Source| VozPopuli, The Economist

More Info| Diego Sánchez de la Cruz, Periodista Digital

Image| Bailouts, Taxes

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Legal Intern at Garrigues

Double degree on Law and Business Administration at Pablo de Olavide University.

Participant in Moot Madrid 2014 on International Commercial Law and International Arbitration.

Erasmus Programme at Nicolaus Copernicus University (Torun, Poland).

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