More recent banking system experience worldwide indicates unprecedented costs of banking system distress – an unprecedented high frequency of banking crises, many bank failures, and large losses by failing banks, sometimes with disastrous costs to taxpayers who end up footing the bill of bank loss. This new phenomenon has been traced empirically to the expanded role of the government safety net. [Emphasis DC] Government protection removes the effect of market discipline. It thereby encourages excessive risk taking by banks, and also creates greater tolerance for incompetent risk management (as distinct from purposeful increases in risk).
Ironically, the government safety net, which was designed to forestall the (overestimated) risks of contagion seems to have become the primary source of systemic instability in banking.
Calomiris makes an excellent point here, but the recent events with Northern Rock show that a commitment never to intervene is not a solution.
Firstly, bank runs can sometimes be panic-driven with the amount of information available completely swamped by the noise; in these cases, it makes sense for the government to intervene to stop the fire from spreading, much the same way as with a real house burning due to its owner's carelessness or otherwise.
Secondly, even if that wasn't a consideration, public and 'stakeholder' opinion is miles away from accepting such a solution. Central bank independence in setting interest rates was a walk in the park; with banking crises, there are real, visible victims - even if only due to their own folly. The governor of the Bank of England and the Chancellor were not critisised for intervening, they were critisised for doing 'too little, too late'.
As I said before, given these political constraints, the Northern Rock crisis was handled in the best way possible.
Don't let banks fail, but Give Them Pain. Make their share price go like this and break their CEOs' hearts. The government safety net should deliberately be porous and whimsical, but it should be there - if only because it is impossible to do otherwise.
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