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Economist Xavier Freixas: How Bank Bailouts Lead to Unequal Risk-Sharing and Taking

January 30, 2011

Professor Xavier Freixas discusses how the social costs (externalities) associated with bank failure necessitated their bailout; but the guarantee to pay for these same social costs also allowed banks to over-leverage (invest too much without holding sufficient reserves to cover risk) their investment portfolio.

He mentions three steps to take to reduce the cost of a banking crisis on taxpayers:

  1. A consistent banking and bailout procedure to minimize the cost to tax-payers
  2. There is legal certainty to this procedure
  3. Is known in advance to those holding stocks of financial institutions

I am inferring that what he is proposing is basically an extension of the  type of rules the U.S. has to insure Bank deposits. Basically, this would be a centralized insurance mechanism that banks would pay into in order to insure against failure. He believes that if there was a legal guarantee that the government would not step in to bail out banks aside from this mechanism; then using the government as a risk-sharing mechanism with  public money would be minimized, and banks and shareholders would have less incentive to encourage speculative investment.

The problem with his proposal is that this system is still unlikely to be sufficient in the case of systemic failure (what occurred during this last crisis) when all the banks suffered from asset price contraction and uncertainty, freezing up the sector as a whole. He does allude to this problem when he mentions the failure of Basil III to institute a sufficiently international approach to banking regulation and bailouts, but doesn’t explicitly mention a solution to the issue. One problem which Europe is currently facing is that banking bailouts have occurred on a country-level basis when their effects are intra-regional (in terms of the EU) and international.

Professor Xavier Freixas is correct when he states that the recession’s banking crisis has had international consequences which must be addressed and that never have so few (bankers) owed so much to so many (the general public who have allowed bankers to take risky gambles through guaranteeing and paying out massive bailouts in the case of failure).

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One Comment leave one →
  1. February 1, 2011 9:16 am

    Be sure to check out the accompanying article on the Barcelona Graduate School of Economics website: http://www.barcelonagse.eu/never-before-freixas.html

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