A refrain heard a bit too much lately is that certain companies, particularly banks, are too big to fail.   If this statement reflects the fact that big organisations only grow to a large size due to strong management capabilities, i.e. that size reduces the probability of failure, then there maybe an element of truth to this statement.   However, the normal meaning applied to the "too big to fail" moniker is that the fallout following the collapse of a major institution will be so catastrophic for the rest of the economy and society, that propping up the rotting carcass is the best of a bad set of options facing the economy.   But ultimately this becomes a question of who should pay for the mess: the greedy and stupid investors, their incompetent management team or the ultimate patsy, the taxpayer?

In the normal course of events, and these admittedly are not normal times for the global economy, economists view the occasional business failure as having positive consequences for overall economic performance.   The failure knocks out less prudent investments and/or poorer management teams, it provides an illustration to others of the consequences of poor business decisions, and it speeds up the process of reallocating resources into the hands of more productive management teams.

As my colleague, Matt Nolan explained recently (Dominion Post, 3 Dec 2011), there are special circumstances relating to the banking sector, where otherwise solvent banks can be made insolvent as the result of a panic induced run on the bank.   If unchecked, such panics can lead to a contagion effect that can undermine the solvency of the entire financial system.   Indeed, protecting the financial system from the contagion of bank runs was one of the primary reasons for the creation of central banks like our Reserve Bank.   Concern for the plight of innocent depositors is also behind the many deposit protection schemes that became vogue in the aftermath of the Lehman Brothers collapse in 2007.

Financial systems ultimately depend on trust in the system, so having a government sponsored guarantee for the system is very important.  However, it seems that system protection is often confused with investment protection.   The aim should be to protect the depositors, not the investors or their management team.

It is the return on capital that makes or breaks an investment project.   Net annual revenue of $1m is great on a $5m investment, implying a 20% return, but does not look so great if it is based on a $50m investment (implying just a 2% return).   Paying for the consequences of a bank that makes a number of bad deals, say from buying Greek government bonds, could potentially harm the Bank’s net revenue position.   If the Bank finds that it cannot cover its bad debts it will potentially go to the wall, taking its depositors and creditors with it.   If the government or its central bank steps in to help the struggling bank, they save the creditors, depositors, and potentially the whole financial system.   The downside is that the bill is paid by the country’s taxpayers and the prime beneficiaries are the owners of the bank who maintain their wealth despite being the agents of the original problem.

Why should the investors, whose greed and incompetence caused the problem, benefit from the bail out?     What signal does this give to other financial institutions?   An alternative to a bailout would be for the government to nationalise the bank and facilitate its purchase by a new group of investors.   As the net asset position will include the liabilities accumulated by the previous owners, the purchase price of the bank might be very low or even negative (i.e. the government might need to pay someone to takeover the business).   But whatever revenue earned from the sale would go towards compensating the government (and ultimately taxpayers).

The nationalisation allows the bank to continue as a going concern, and so protects the interests of depositors, creditors and the financial system in general.   The privatisation of the assets means that the assets can be transferred into the hands of a new ownership team, and at a price that will make the investment viable for the new team. Well, at least initially.   The added bonus is that the initial investors bear a substantial cost for their poor performance, which will provide a strong message to other banks of the importance of having prudent lending practices.