Bagehot or Bailout - An Analysis of Government Responses to Banking Crises

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Bagehot or Bailout? An Analysis of Government Responses to Banking CrisesAuthor(s): Guillermo RosasSource:

American Journal of Political Science,

Vol. 50, No. 1 (Jan., 2006), pp. 175-191Published by: Midwest Political Science AssociationStable URL:

http://www.jstor.org/stable/3694264

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Bagehot

or

Bailout?

An

Analysis

of

Government

Responses

to

Banking

Crises

Guillermo osas

WashingtonUniversity

Politicalntervention ntomarketscantakeanearlyendlessnumberofforms.Duringthelatterpartofthe twentiethcentury,therewas awidelysharedsense thatgovernmentsshoulddecreasetheirrolein theeconomy.Still,therewereimportantvariationsin thistrend. Inresponseoonerousbankingcrises,countrieschosepoliciesthat varieddramaticallybetweenrescuingnsolvent banks(Bailout)andenforcingbankclosures(Bagehot).Bailoutsareoftenportrayedasregressivewealthtransfersfrom axpayersobankersas theresultof "crony apitalism."However,governmentpolicychoicemaybepatternedasmuchbydomesticinstitutions-politicalregimeandcentralbankautonomy-andinternationalconstraints-economicopennessandsupport rominternationalfinancialinstitutions-asby politicalpromisesto standby cronyallies inhardtimes.Itest theseargumentsbyfittingaBayesianhierarchicaltemresponsemodelofpolicy makingthattakesfulladvantageofdata ongovernment responsesobankingcrises.

nrecentyears, bankingcrises havewreakedhavocinless-developedanddevelopedeconomiesalike,caus-ingdirect lossofwealth tobankers,depositors,andtaxpayersand deleteriousindirect effectsoneconomicgrowththrough abruptcreditcrunches.Inresponsetotheseevents,somegovernmentshave chosentoupholdmarketoutcomesbyclosinginsolvent banksandforc-ingbankers anddepositorstotake losses.ThistypeofpolicyresponsefollowsbroadguidelinessetmorethanacenturyagobySir WalterBagehot.Othergovernmentshaveallowed insolventbanks tocontinueoperations,ineffectsubsidizingthelossesofbankersanddepositorsandshiftingthe burden ofbankinsolvencytotaxpayers.Theheftycosts shoulderedbytaxpayersandthe obviousmoralhazard incentivesthataccompanybankbailoutsmakeitimportanttounderstand theconditionsunderwhichpoliticiansrescuebanks:Whyisitthatsomegov-ernmentschoose to bailbanks outwhenconfrontingasystemicbankingcrisis(Bailout)whereasothers re-main"close to themarket"andallow failuresofinsolventbanks(Bagehot)?Andmoregenerally,whatare thecon-ditions underwhichpoliticiansrescuebankrupt privateconcerns?Oneappealinganswertothispuzzlecan bepiecedtogetherfrom"cronycapitalism"narratives.This termisusedcolloquiallyto refer ocozy,nontransparentrelationsbetweenpoliticiansandentrepreneurs.Within thelogicofcronycapitalism,politiciansact as the "executivecom-mitteeof thebourgeoisie,"shamelesslydevotingpublicresourcesto make bankswholeagainin the eventofcri-sis.Yet,thislogicfails toacknowledgethatpoliticiansareagentsofmultipleprincipalsandmightface incentivestorenegeonpromisesto cronies.AsMaxfield(2003)andKeefer(2002)argue,domesticinstitutionsmightshiftthepoliticalcalculusofbailoutssuchthatcronylinksmaynotnecessarilydeterminegovernmentresponsestobankingcrises.Thus,eventightrelationsbetweenpoliticiansandbankersmayfailtoproducebankbailouts.Mycontribution tothisdebateis twofold.First,Ibuild andestimateaBayesianmodel ofgovernmentbailout

GuillermoRosas s assistantprofessorofpoliticalscience,WashingtonUniversitynSt.Louis,CampusBox1063,OneBrookingsDrive,St.Louis,MO63130-4899(grosas@wustl.edu).Iappreciateommentsonpreviousversions ofthisarticle from GabrielAguilera,BrianCrisp,RobertO.Keohane,PeterLange,AndrewMartin,RobertMickey,ScottMorgenstern,KarenRemmer,AndySobel,threeanonymousreferees,andfrom audiencesatITAM,DukeUniversity,UCLA,andWashingtonUniversity.'TheliteratureattributeshesystematizationoflastresortlendingtoBagehot(1873).Unknowingly,Bagehotexpandedthe doctrineoflast resortlendingcreatedbyThornton(1802),whichpurportedtoprotectanation'smoneystockduring bankingcrisesbylendingtoilliquidinstitutions ata discountandonlyongoodcollateral.AccordingoBagehot,nstitutionsthatcannotpost goodcollateralhouldbeconsiderednsolvent,andthusnotworthyofliquiditysupport:"Anyaid toapresentbad bank isthe surestmode ofpreventingheestablishmentofafuture goodbank"(Bagehot(1873),quotedin HawkinsandTurner1998,36)).Seealso Freixastal.(2000).AmericanJournalofPoliticalScience,Vol.50,No.1,January006,Pp.175-191?2006,MidwestPoliticalScienceAssociationISSN0092-5853175

GUILLERMOOSAS

propensitiesthatthoroughlyexploitsavailable informa-tion aboutpolicyimplementationduringbankingcrises.Previousstudies of the determinants ofbank bailoutsrelyeither on"fiscal cost" measurements(HonohanandKlingebiel2003)2oron alimitednumberof policychoiceindicators(Keefer2002;Nava-Campos2002;Rosas2002).Thesemodelingchoicesarenotalwaysappropriate.Theuse of fiscalcosts ofbailoutsasaproxyforgovernmentresponseconfoundspolicychoicewiththe eventual eco-nomicoutcomesthatfollowfromthischoice.Asidefromthe fact thatpolicychoice islogically priortoits eco-nomiceffects,it isnot obviousthat thesizeofthe bailoutbill iswhollydeterminedbythesamefactors that affectgovernment response;therefore,it isdifficult toarguethat fiscalcosts aregoodindicators ofpoliticalactiontoredressbankingcrises.Moreover,limitinginspectionofpolicychoiceto a handful of indicatorsfails toexploitdetailedinformation about the characterofgovernmentresponse.Alongtheselines,my analysisreportsthat someoftheindicatorscommonlyused asdependentvariablesin thesestudies areamongthe leastinformative aboutgovernmentbailoutpropensities.Insteadofselectingde-pendentvariablesapriori,themodelingapproachthatIpursueallowsthe data to"speakoritself,"thusallowingamoreappropriateselection ofkeyindicatorstoinspectin futurebankingcrises.Second,Isuggestthat "basic"domesticinstitutions-namelythedemocraticor authoritariancharacterofpo-liticalregimesand theautonomyofcentralbanksfrompolitical pressures-arelikelyto influencegovernmentre-sponsestobankingcrises.Ialsoacknowledgethat domes-tic institutionsare nottheonlydeterminants ofbailouts,butthatpoliticiansmightchoosepolicywithaneyetotheinternationalconsequencesoftheiractions.Inparticular,Iconsidercapitaland tradeopenness,thedegreeofinter-nationalizationof a nation'sbankingsector,andsupportfrom international financialinstitutions,asargumentsinthepoliticaldecisiontobailout banks.Thearticlesorganizedas follows:FirstIputforth twoideal-typesofgovernment response, BagehotandBailout,thatcapturethebasic dilemmas thatpoliticiansconfront

2Fiscal costs areconceptualizedas theestimated amountneededtorestore bankstosolvencyasapercentageofdomesticGDP. Inad-dition to the reasonscited inthetext,estimates offiscal costsvaryagreatdealdependingonwhethertheyaremeasuredattheheightofacrisisorafterwards(Eichengreenand Arteta2002).Moreimpor-

tantly,iscalcosts ofinsolvencyneednot beimmediatelyrealized,but theirpaymentcan bedelayed.Forexample,the Mexicangov-ernment assumednonperformingbankloansduringthe1994-95crisisinexchangeor10-yearcoupon-bearingbonds.As aconse-quence,fiscalcosts canfluctuatedependingonpost-crisis policy.Inparticular,naggressivepursuitof borrowersn arrearsmight

duringbankingcrises,andsuggesthowpubliclyavail-ableinformationregardingpoliciesimplementeddur-inga crisis canbe usedtoelicit informationabout thebailoutpropensityofdifferentgovernments.I thenana-lyzethe determinantsofpolicychoice to counterbankingcrisesandsubmittheoretically guidedhypothesestoex-plainbailouts.Next,IdevelopaBayesianmodelofpol-icychoice thatappropriatelyaccountsforpeculiaritiesofthedataandthen testmodel onasampleof46observa-tions.Finally,concludeandsuggestdirectionsforfurtherresearch.

PolicyChoice

I define "bankrescue"or"bank bailout"asanygovernment-sponsoreddelaynthe exitof insolventbanksthatisexplicitlyorimplicitlyfundedbypublicresources.Inotherwords,abankis bailedoutifitcontinuestooperateafterinsolvency.Note that bailoutsdonotneces-sarilyentailmoneyhandoutsfromgovernmentsto banks.Bailouts alsooccurwhengovernmentsalter bankregula-tioninordertochangethelegaldefinition ofinsolvency,evenifno transferofpublicmoneyisimmediatelyreal-ized.3Thus,any policythatartificiallyextendsthe lifeofinsolvent banksisabailout.Note alsothat,inlinewiththisdefinition,bailoutsshouldnotbeseenas discrete"either/or"events.Instead,itisappropriateto considerbailoutsasrangingin the abstractfromabsolutelynogovernmenthelptocompletegovernmentabsorptionofalllosses.Tosimplifythediscussion,Ireferinthissection totwo extremeformsofgovernmentresponse:BagehotandBailout. Betweenthese twoextremes,Ipositthatgovern-mentsvaryintheirpropensitytowardbailoutsandthatthesevaryingpropensitiesare determinedbydomesticinstitutions,acountry'sinsertionintheglobaleconomy,andthe structureof thenation'sbanking system.Ontheonehand,theBagehotrule,which aimstoprovideliq-uidityto solventbanks andto force the exitof insolventinstitutions,isthe classicalpolicy responsetobankingcrises.Bagehotis the choiceof agovernmentconcernedwithupholdingthemarketmechanismanddiminishingmoral hazard incentivesin thebankingsector.This solu-tionminimizesimmediatepublic outlays-i.e.,itavoidssocializationofbank losses-andeventually strength-ensthefinancialsystembyeliminatingweakbanks,butitstenabilityispremisedon theassumptionthatgov-ernmentshaveperfectinformationabout thefinancial

3Forexample, droppingcapitalizationrequirementsduringabank-

ingcrisisis tantamountto abailout,for banks deemedinsolventdiminish thesize ofthe bailoutsubstantially.176

underthe "old rules" areallowedto continueoperations.

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