Instead of bailing out the institutions, why didn’t the government just let them fail and give the money directly to the people hurt by the bank’s mismanagement? Why were the banks’ protected? Doesn’t this kind of protection incentivize banks to act recklessly in the future?
In: Economics
At its core, a banking system is a system of trust. ie. If a bank lends money to another bank, there’s a certain level of trust that they’ll be paid back, with some interest (the overnight lending rate).
During the financial crisis, there were rumours that certain banks didn’t have enough cash to operate. As a consequence, banks no longer felt comfortable lending money to other banks. Nobody wanted to be in the situation of losing hundreds of millions of dollars from an overnight loan to a bank that just went bust the next day. So as a result, lending simply dried up, and interbank interest rates went through the roof. All this happened because all these banks didn’t know which other banks were on the verge of bankruptcy (ie. running out of cash). This freezing of credit then spilled over into commerce; regular businesses couldn’t borrow money either to finance their day-to-day operations. This was a big deal. The U.S. economy was on the verge of halting, and then collapsing.
So, the Federal government stepped in and basically forced all the big banks to accept huge loans from the Federal government. This way, everyone could see that all these big banks had plenty of cash and not in any cash crunch. Banks that didn’t need Federal cash were forced to accept, because banks that refused this Federal cash would mean the banks that *did* take the cash were the ones in actual trouble, which would collapse those banks because everyone would know not to lend to them, which would make this whole operation pointless.
This is an extreme over-simplification of what happened, but it should give you an understanding of why the Federal government bailed out the large banks, and why there were few other options, given the time crunch.
The alternative would have been much, much worse.
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