Question

Based on the functions of the banking system, give reasons why governments bail out banks during an economic crisis?

Answer 1

During an economic crisis when the banks are making huge losses and at risk of collapse the government usually bail out banks. It is important to bail out banks because the banking collapse can cause a negative multiplier effects on the aggregate demand and the loss of the jobs. The severe decline in the confidence and trust in the financial system risks may result to a deflationary depression instead of a cyclical recession. Furthermore it can squeeze the lending to small and medium-sized entities that requires borrowing the funds to stay in business or finance capital investment. The bailout helps them in consolidating the payment and borrowing timeframes

For example, the banks may borrow from deposits and loans are offered to the consumers. But as the deposits timeframe is short but the investments payment time is long, thus it is likely that the clients may lose confidence in the bank. Banks faced by this sort of problems of predicament rely on bailouts as it provides a way that they do not have to liquidate for the payment to the clients. Moreover the majority of the banks do not have primary assets on the settlement at times for financial problems.