Question

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

Answer 1

Governments have to bail out banks during an economic crisis because banks are an indepensable parts of the economy. A big bank has so many connections with so many diverse industries that if it fails, it can bring the entire system to a standstill. Banks provide credit and other services like working capital management etc to almost all the industries. Doing such transactions with a bank requires a good amount of trust because large sums of money have to be borrowed and lent on just the name and reputation of the parties involved. Because such transactions are done with reputation, no collateral is involved to secure the loans and other borrowings and lending. Hence, if this one big bank fails, it can lead to a domino effect where in all other industries and companies associated with it will also suffer and it can hamper the economy badly. Hence, it is more prudent for the government to bail out the bank instead of allowing it to fail.