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The too big to fail myth

Written By: - Date published: 8:17 am, February 5th, 2011 - 33 comments
Categories: capitalism, Economy, International - Tags: ,

Business likes to privatise the profits and socialise the losses. All over the globe we the tax payer recently got stuck with a bill for trillions of dollars to bail out banks that were “too big to fail”.

Or were they? One country went against the trend. Iceland. You may recall that Iceland was foolishly exposed and very hard hit by the financial crisis. When the house of cards came down Icelands debtors put pressure on the government to follow the script, and bail them out with public money. But the people of Iceland (causing an international incident in the process) stood up and said no.

What happened next? Iceland let its banks go under:

… Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

It was a risky decision and it was a bumpy ride:

… The crisis almost sank the country. The krona lost 58 percent of its value by the end of November 2008, inflation spiked to 19 percent in January 2009 and GDP contracted by 7 percent that year. Prime Minister Geir H. Haarde resigned after nationwide protests.

But is has proved to be the right move in the long run:

With the economy projected to grow 3 percent this year, Iceland’s decision to let the banks fail is looking smart — and may prove to be a model for others.

“Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. …

Arni Pall Arnason, 44, Iceland’s minister of economic affairs, says the decision to make debt holders share the pain saved the country’s future. “If we’d guaranteed all the banks’ liabilities, we’d be in the same situation as Ireland,” says Arnason, whose Social Democratic Alliance was a junior coalition partner in the Haarde government. …

Today, Iceland is recovering. The three new banks had combined profit of $309 million in the first nine months of 2010. GDP grew for the first time in two years in the third quarter, by 1.2 percent, inflation is down to 1.8 percent and the cost of insuring government debt has tumbled 80 percent. Stores in Reykjavik were filled with Christmas shoppers in early December, and bank branches were crowded with customers.

The article quoted spends a lot of time comparing Iceland with the Irish experience. Ireland was also over exposed and indebted, but chose to bail out its banks:

Ireland, which rescued its financial institutions, is on the way to shrinking for a fourth consecutive year.

Banks are not too big to fail at all. And since we seem to have decided not to fix the world’s fundamental financial problems, greed will soon lead us down the same old path to the next implosion. Let’s all remember Iceland when the banks come to us again with their hands out.

33 comments on “The too big to fail myth ”

  1. While in NZ, our government feels the need to bail out even the likes of South Canterbury Finance.

    This, of course, has NOTHING to do with their fatcat mates standing to lose money.

    • jcuknz 1.1

      I like your idea Rob and Iceland seems to be a good argument towards it. But what happens to the Mum and Dad investors who, rather than get that extra one or two percent on their meagre savings, choose to put their money into the main banks rather than all the numerous investment companies that went to the wall over the past few years?

      This is a question I never see answered and its personal because short of under the mattress where can a small time saver put their money with assurance?

      I think one should compare oranges with oranges rather than apples and SCF I thought was just another finance company rather than a bank. Though perhaps the government has learnt a little bit and I hve read reports that an orderly sell off of SCF will result in the loss being considerably less.
      Perhaps the solution is governmental supervision of sell-offs rather than liquidators selling to the highesst of the low bidding sharks?

      • The Voice of Reason 1.1.1

        They could put their money in Government bonds or any number of safe places that offer modest returns. The Icelandic banks that went down were offering above average returns that simply were not sustainable. They were closer to SCF in the way they worked, rather than Kiwbank.

        Anyway, if ‘mums and dads’ want to gamble their savings away, as far I’m concerned it’s entirely their business. Nobody bails me out when I back losers at the TAB, so why am I required to compensate the greedy or the naive?

        • Colonial Viper 1.1.1.1

          The Icelandic banks decided to take large deposits from many dodgy corners in order to expand their balance sheets. Including Russian oligarchs and the Russian mafia.

          Nobody bails me out when I back losers at the TAB, so why am I required to compensate the greedy or the naive?

          In fact, the naive ‘mum and dad’ depositer does need protecting to some degree from the financial sharks. And Richard Long, etc.

          However there were many large players who knew exactly what they were doing (to the tune of tens of millions) when they helped force the failure and subsequent bailout of SCF.

          My thought was that for the first $100K-200K in deposits, small investors in SCF should have been fully refunded. That would have protected small depositer’s retirement accoutns etc. Above that increasing losses should have been applied. Over $500K in deposits probably only 50c on the dollar should have been paid out.

          • Herodotus 1.1.1.1.1

            My thought was that for the first $100K-200K in deposits, small investors in SCF should have been fully refunded.
            CV the liquidator would not have total control and to act over the Finance coys “Assets”, and would be open to charges of treating creditors with similar rankings being treated differently, just on the basis of $$. I am sure Cullen was a ware of this when the guarantee was passed.
            A smart investor would then deposit amounts max to the ceiling amount allowed, over many finance coys. There still would have been a run on funds pre-empting coys to fold more quickly. The govts protection leg was just another example of giving lip service.
            The base controls e.g. reporting, disclosure, related parties etc were amiss, many times the issue can be brought back to a few simple issues. And the interest that many were paying out to investors were inadequate to the real risk. So why should a govt bond, the big 5 banks pay a 1%-2% less in return for far reduced risk and we “Labour and Nat” then help out these people who wanted to be greedy and wanted this wee increase in returns. No wonder we are financially illerate, then want the govt to bail us. Thanks to Cullen and English for not following Darwin, in the fittest survive- no we just have strengthened the annelid family.

      • Draco T Bastard 1.1.2

        This is a question I never see answered and its personal because short of under the mattress where can a small time saver put their money with assurance?

        Nowhere you idiot. When you loan out you’re money, and sticking it in a bank or other financial organisation is loaning it out, you take the risk that you’re not going to get it back. Apparently, it’s the risk that justifies the interest return – it sure as hell isn’t because you’re doing anything worthwhile.

        • KJT 1.1.2.1

          That’s why people buy houses or land. The bank cannot destroy it.

          And why should any one be able to make more money just because they own money. The whole idea is stupid when you think about it as the only true source of wealth is real work or real resources.

          • Colonial Viper 1.1.2.1.1

            That’s why people buy houses or land. The bank cannot destroy it.

            The banks already figured that one out – simply get people into debt and foreclose on them.

            Classic in the US – one family had their house taken away from them not because they had not paid their mortgage – but because of a US$75 contested late fee.

        • jcuknz 1.1.2.2

          Since what I have is the result of building an asset, with my hands, which somebody wanted I think I worked for it and further additions are the result of not spending. I am well aware that my funds are unsecured. But if the government wants people to save then collectively we all need to back them to stop small savers loosing out. That to me is socialism in practice. But I guess DTB is an abusive and brainless RWNJ butting in on what I hoped would be a sensible discussion.

    • infused 1.2

      The US was on a bit of a difference scale to Iceland. There would have been massive consequences to the entire world if the US had done the same. It would have been nice to let them fail, I believe the same way. Like the whole GM thing, they really should have let it go under, but the consequences of actually doing that were great.

      • Colonial Viper 1.2.1

        Possibly right – could not have let the entire US financial system fail. Shareholders and bond holders in the big banks should have taken very sharp haircuts however. There is no way those investors should have got 100c in the dollar from tax payers, and on certain deals, the banks should have been made to wear 100% losses.

        Its also amazing that the US Govt isn’t now a majority shareholder in all the major banks they bailed out, given that those banks went cap in hand for billions that they could get from absolutely nowhere else.

        And even though the big banks got bailed out of their own predicaments, homeowners got the shaft. Millions of Americans have been losing their homes to foreclosure every year. In fact, last year it became clear that certain banks were profiteering through the ‘foreclosure fraud’ scandal.

        In other words, the US financial economy got bailed out and the US real economy – the one which provides 90% of the jobs – was allowed to keep slowly dying.

        http://www.reuters.com/article/2010/01/14/us-usa-housing-foreclosures-idUSTRE60D0LZ20100114

        Further, what happened was that some banks – e.g. Goldman Sachs deliberately engineered aspects of the financial crisis to be as big as possible. Their bets that (for example) AIG would completely fail paid off in the billions – and they are now making bigger profits and giving out bigger executive bonuses than they were before the GFC. All by using gifts of free tax payer money.

        http://www.businessinsider.com/goldman-sachs-made-billions-shorting-aig-2009-3

        The big banks, in a brilliant show of brinksmanship have also completely successfully resisted calls to be broken up and for bans to be placed on high risk, highly toxic proprietary trading.

        • infused 1.2.1.1

          Yeah I agree with that. The banks totally rooted everyone. IMO, the govt should have a stake in all these banks now.

  2. lefty 2

    What should happen to ‘Mum and Dad’ investors is the same as what happens to anyone who gambles at the casino or the race track. They lose their money if they make the wrong bet.

    Investors get paid interest for doing nothing, but too many are not content with moderate returns. They want to make superprofits off other peoples labour, then have the rest of us bail them out when it goes wrong.

    The only financial institutions the taxpayer should stand behind are the ones they own like Kiwibank and these should be expected to adhere to high ethical standard in how they use depositers funds.

    Debates around savings are particularly toxic at the moment.

    We are being pushed into believing that state pensions will place an impossible burden on future generations, but magically savings are supposed to be able to attract a high rate of return on the labour of future generations without placing any burden on them at all. Giant pension funds are scouring the world searching for high returns, distorting economies and encouraging a casino mentality. Individuals are also encouraged to gamble with their savings through investment portfolios that focus on maximising returns. The focus on high returns discourages investment in the productive sector and encourages speculation. One alternative is to channel savings into state owned banks that invest them in productive activity at a moderate rate of return which would develop healthy economies that could well afford to pay decent state pensions as well as ensuring the safety of the savings and minimise the risk and burden on future generations.

  3. Afewknowthetruth 3

    Oh dear. Iceland managed GDP growth.

    That’s a very bad sign, since GDP is an entirely false measure of the well-being of a nation and corresponds with squandering of resources, destruction of the environment and destruction of the social fabric.

  4. Locus 4

    This link gives a reasonable explanation of why in the 18 and 1900’s it was a good thing to provide government protection to prevent bank runs. http://decouple.org/the-news/47-bank-run
    The trouble is that financial institutions have now come to expect that they’ll be bailed out, and that, combined with no regulatory control, has encouraged them to lend on ridiculously risky bases. We all need somewhere to know that our cash is safe, and under the mattress isn’t the answer. I also don’t think that the answer is to punish the naively optimistic and/or gullible people who deposit their life savings in risky schemes. I’m not convinced that letting the Icelandic banks go under is going to guarantee that the same sad cycle won’t repeat in the future. A nation’s financial system will always need a safety net, but the time has come for institutions to pay a much larger premium for the ‘safety net’ and for governments to enforce higher liquidity ratios that reflect the social costs of failure.

    • Colonial Viper 4.1

      You can’t consider high risk proprietary/derivatives trading as being part of the basic utilitarian banking system that society needs to have in order to run a modern economy. That kind of trading must be broken up and taken away from the banks.

      And there is absolutely no reason that the public should underwrite those high risk highly toxic activities either – some of those derivatives exist only to generate bankers bonuses, not help the real economy complete any kind of necessary commercial transaction.

      • Draco T Bastard 4.1.1

        Some of that type of trading needs to be stopped altogether.

        • Colonial Viper 4.1.1.1

          But…then how will the banks make their illusory profits which enable their executives to be paid out with real bonuses? Bonuses they will keep when they run their next boom and bust cycle.

  5. prism 5

    This is a good thread to pass on this interesting and informative article on Ireland’s financial machinations. Long it is, but wisdom, and even a laugh may ensue!

    http://www.vanityfair.com/business/features/2011/03/michael-lewis-ireland-201103?currentPage=all

  6. Michael 6

    The Standard calling for Free Market economics? Actually, you are right on this – the banks that have been swept away have been replaced by ones that won’t make the same mistake. In NZ both Labour and National shouldn’t have issued guaruntees to Finance companies and banks. It might have meant the secondary market would have collapsed earlier and 2% higher borrowing costs, but it would mean that people would be making decisions based on risk and reward, not on chasing the highest return.

    • Draco T Bastard 6.1

      From me it’s not so much calling for a free-market but that, if they’re going to profess the principles of such a market then they damn well should pay the price when the risk that they use to justify their income from nothing falls due.

  7. Jan 7

    The alarming backstory is now playing in cinemas. The Inside Job is well worth taking as may friends as you can muster. http://www.sonyclassics.com/insidejob/
    I can’t say I have a view on the “too big too fail”. Just that power and politics are operating both here and overseas in the decisions about which financial institutions have been rescued at taxpayer expense and how.
    http://www.sonyclassics.com/insidejob/

  8. vto 8

    Great post r0b.

    But watch out, because what you have pointed out is that the free market does in fact work better than government intervention.

    • Jeremy Harris 8.1

      I completely agree, this is the first post on The Standard I can remember when I found myself physically nodding…

      It quite clearly demonstrates what economic rubbish the “standard” economic line on this blog is…

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    The Crown is taking a new approach to takutai moana applications to give all applicants an opportunity to engage with the Crown and better support the Māori-Crown relationship, Treaty of Waitangi Negotiations Minister Andrew Little says. Following discussions with applicant groups, the Crown has reviewed the existing takutai moana application ...
    BeehiveBy beehive.govt.nz
    1 week ago