NCPA - National Center for Policy Analysis

The Dilemma of Bailouts

July 20, 2011

Bailouts, with reason, are much disliked.  They not only abuse the taxpayers who have to pay for them but also disregard the free market theory that maintains that bailouts prevent market forces from bringing about necessary corrective moves, says Roy C. Smith, a professor of finance in the Stern School of Business at New York University.

Until now, however, the market has known that government officials prefer bailouts to a global financial or economic disaster and that when faced with such a possibility they will decide in favor of bailing out the threatened institution rather than letting it fail. 

  • The basic argument for bailing out large banks is that a single failure of such a firm can contaminate the whole financial system, which is a public good that the government must safeguard.
  • The irony of bailouts is that whether a government carries one out or not, the government will still be involved economically in the situation that created the demand for a bailout.
  • Indeed, after Lehman Brothers failed, the Federal Reserve's own balance sheet increased by more than $1.5 trillion owing to its various market-support efforts.

By being willing to bail out large banks, however, the government provides these banks with a free, valuable subsidy of their funding costs and accepts the moral hazard that such guarantees create.  Both of these effects may entail great costs for the operation of the financial system.

Andrew Haldane, executive director of the Bank of England, tried to estimate the annualized cost of the too-big-to-fail subsidy.

  • Assuming an intervention of $100 billion in the United States every 20 years, he calculated the annual premium on an insurance policy of that amount to be less than $5 billion a year, to be shared by, say, 20 banks.
  • The top five banks would pay most of this premium.
  • However, if the cost of lost domestic economic output from a banking crisis were included, then, according to Haldane, the combined cost would be well beyond the banks' ability to pay.
  • Thus, he argues, the true cost of systemic risk in the United States is huge, and the government has to be realistic in thinking about how to bear it.

Source: Roy C. Smith, "The Dilemma of Bailouts," Independent Institute, Summer 2011.

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