A bank bail-out is a form of government intervention in the financial system to prevent the failure of a financial institution. This is typically done by injecting large amounts of capital into the bank or by providing a guarantee on its liabilities. The objective of a bail out is to prevent a systemic crisis in the financial system, which could lead to a collapse of the economy. Bail out funds are therefore only available to systemically important financial institutions.
Governments bail out financial institutions to protect the economy and to help ensure that their citizens have access to the financial services they need. Bailing out financial institutions can help prevent financial instability and prevent a deeper economic crisis. It can also help to protect jobs, maintain confidence in the banking system, and prevent the failure of other businesses that rely on the banking system.
There is quite some public criticism about bank bail-outs since they may encourage unnecessary and excessive risk taking that lead to moral hazard. Bank customers are reticent to punish wrongdoing because they are aware that public money and taxpayer eventually protects their investment. A bank bail-out can distort the competitive landscape and create an uneven playing field. By protecting certain banks, bailouts can limit competition and lead to an inefficient allocation of resources. Furthermore, if some banks are bailed out while others are allowed to fail, it can create an unfair advantage for the bailed-out banks and lead to long-term economic inequality.
Bank failure and bank bail-out potentially disrupts confidence in the financial and payment system. Over the years, several policy responses were initiated to mitigate the risk and ultimately avoid bank bailouts. These include the increase of capital requirements, a strengthening of risk management practices, and the establishment of contingency funds. Additionally, specific financial institutions are designated as systemically important financial institutions and subject to additional oversight, regulation and capital requirements. Where credit institutions cannot be rescued or their continuation is not justified in the public interest, a bail-in mechanism may avoid tax payer input by orderly winding up the failed bank like any other commercial enterprise on the market.