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Evaluate Whether A Central Bank Should Ever Allow A Retail Bank To Fail.

Date : 03/08/2018

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Charles

Uploaded by : Charles
Uploaded on : 03/08/2018
Subject : Economics

The performance of Citigroup, one of the largest US retail banks, has recently improved. The bank had suffered huge losses during the financial crisis of 2008 and it had to be rescued by the US central bank and government.

Evaluate whether a central bank should ever allow a retail bank to fail. (25 marks)

A retail bank is an institution that aims to make a profit by selling banking services to its customers. It does this by providing current and savings accounts for customers, credit and debit cards and most significantly creating deposits (money) that is then lent to customers who are willing to borrow. The loan may be spent on things like cars, houses or consumer durables.

Loans are assets for banks just like machinery is an asset for a normal company. Loans are how banks make most of their revenue and profits. There is thus a strong incentive for banks to lend. A retail bank will fail if its bad non- performing loans wipe out the bank’s capital (shareholder equity). Central Banks fear a retail bank failing because they believe that it may have catastrophic consequences for the whole economic system.

Should a bank fail there is likely to be a crisis of confidence. People think, will I lose my money? This leads to contagion. Depositors rush to other banks to withdraw their deposits. Banks will therefore attempt to accumulate reserves to deal with the crisis in confidence. As a result, the inter-bank lending system will freeze and confidence will take another big hit.

Ordinary people will hoard cash at home. As a result, of the hoarding and accumulating of money at home, the velocity of circulation will fall, effectively reducing the money supply. A credit crunch will ensue. The lack of credit will lead big purchases, such as cars and projects being put off. Growth will fall or worse still, the economy will enter a major recession as demand begins to dry up. Prices may begin to fall and a deflationary psychology take hold.

Deflation (falling prices) makes matters worse because the security that the banks were given for their loans is now worth less. Should borrowers default and banks sell the security to recoup the loan, the bank will sustain losses reducing its ability to lend. The reduction in aggregate demand will lead to unemployment, pay cuts as workers fear they will lose their jobs if their employers are unable to reduce their costs. Pay cuts result in even more defaults putting banks in an even more precarious position. It is a catastrophic vicious circle. Central banks usually have a responsibility for controlling inflation, but many others, including the Federal Reserve in the USA, have a responsibility to maintain growth and employment. Should a retail bank be allowed to fail then central banks might think it would be impossible to avoid a depression. Hence, central banks will do whatever it takes to prevent a retail bank failing.

Retail banks realise that the consequences of their failure may be catastrophic and, therefore, unacceptable for central banks. They believe that a central bank will implicitly guarantee their continued existence: the central bank will bail them out if things go very badly wrong. With this implicit guarantee retail banks will change their lending behaviour. Riskier loans will be made, which t means more profits should they be repaid and as a result higher bonuses for the bank’s employees and higher returns for shareholders. Banks will reduce their capital buffers to take advantage of riskier lending opportunities. The retail banks will be acting as profit maximisers. & The problem is that the implicit guarantee to the banks is bringing about the very risky lending and losses that the central banks want to avoid. This is moral hazard: somebody has an incentive to take risks that others will pay for.

Retail banks should not be allowed to fail because they pose a systemic risk. If a retail bank is allowed to fail then there will be enormous collateral damage to people and businesses who have behaved prudently. They will be punished for the actions of bankers who have been handsomely rewarded. However, a situation where profits are private while losses are paid by taxpayers is not sustainable. National debts will just grow and grow to become unsustainable. The financial crash saw losses transferred from banks into budget deficits for governments. The issue of moral hazard has to be tackled and the bankers have to have “skin in the game” so they pay for extremely risky lending too. It may be that the law will be required to correct market failure and that severe prison sentences need to be handed down for those whose behaviour puts the whole economic system at risk. There is a case for more regulation, but regulations can be avoided and the complexity of the financial system means that effective regulation is very difficult. Retail banks should not be allowed to fail but moral hazard must be tackled otherwise massive debts will be passed on to subsequent generations which will not serve the cause of inter-generational equity.

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