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Preventing Financial Bailouts is Hard

Summary:
The title of this WSJ story says it all: Governments in Europe Find Workarounds to Bail Out Ailing Banks For example, Italy’s government approved last month an emergency decree granting a lifeline of up to €900 million ( billion) to Banca Popolare di Bari SCpA, a cooperative bank in the country’s south that has struggled with loan losses from a weak economy. It follows other episodes in which Italian authorities also worked around rules to spare debtholders and even some shareholders, many of whom are local retail investors. In Germany, state owners of troubled bank NordLB recently received the go-ahead from the European Union’s competition authority for a €3.6 billion rescue package after they shot down an attempt by U.S. private-equity firms Cerberus Capital Management and

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The title of this WSJ story says it all:

Governments in Europe Find Workarounds to Bail Out Ailing Banks

For example,

Italy’s government approved last month an emergency decree granting a lifeline of up to €900 million ($1 billion) to Banca Popolare di Bari SCpA, a cooperative bank in the country’s south that has struggled with loan losses from a weak economy. It follows other episodes in which Italian authorities also worked around rules to spare debtholders and even some shareholders, many of whom are local retail investors.

In Germany, state owners of troubled bank NordLB recently received the go-ahead from the European Union’s competition authority for a €3.6 billion rescue package after they shot down an attempt by U.S. private-equity firms Cerberus Capital Management and Centerbridge Partners to buy a stake in the lender. NordLB has struggled for years amid heavy losses in its shipping loan portfolio. Without the rescue, its subordinated debtholders would be on the hook.

The crucial point is that it should have been obvious ex ante that failing institutions and their investors would manipulate the system to avoid the impact of the (well-intentioned) regulation that tried to outlaw bailouts.  Bank failures mean that someone is going to lose money; why would politicians impose those losses on current investors and businesses when they can shift them to future taxpayers by borrowing?

What's the solution? It is hard to think of one so long as people believe government can magically make bank lending safe. That is a pipe-dream, so government should stop trying.  This only encourages more risk taking and ultimately more instability.

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