Bailout – definition and meaning

In finance a bailout is the act of giving financial capital to an entity (such as a company or country) that is dangerously close to becoming bankrupt – in an attempt to save the entity from becoming insolvent.

Bailouts can be profit-driven. Investors may be attracted by the super-cheap share price of a failing business. On the other hand, philanthropists may resurrect an unprofitable business and then turn it into a non-profit organization for the good of society.

Governments are frequently involved in bailing out failing businesses if the failure of the company in question could have a drastic effect on the general public.

Risky behavior from bailouts
Do bailouts encourage so-called ‘too big to fail’ businesses to continue taking too many risks?

Merriam-Webster defines a bailout as:

“The act of saving or rescuing something (such as a business) from money problems.”

Bailouts for the sake of the country

Companies that are bailed out by governments are typically considered to be “too big to fail” as the goods and services they provide are necessary for the country’s general welfare. If the ramifications of a company going bankrupt will cause severe social distress, then that is a signal for governments to do something about it.

Historically the US government has bailed out companies that are thought to be the backbone of the country’s general economic fluency.

For example, American companies that provide or play a role in transportation (such as airlines) would have a negative effect on the general public if they went bust. Therefore, the government may choose to step in and help these businesses prosper through subsidies and low-interest loans.

It is important to stress that government bailouts are typically only carried out if it’s in the best interest of the country as a whole and not just for the sake of the company.

Many economists say there were too many bailouts following the global financial crisis of 2007/2008, resulting in too many zombie companies which attract resources that would be better used in more productive businesses.

Government bailouts – a controversial subject

There has been increasing controversy about government bailouts, especially in the US. During the Great Recession the American government was heavily involved in bailing out the failing American automotive industry.

Many people are against the idea of propping up struggling businesses with government bailouts. Advocates of the free market argue that it is unfair for taxpayers to help a mismanaged company recover and that instead, it should be organically dismantled through free-market forces.

In addition, many see bailouts as a signal for giant companies to be able to lower their business standards and take on more risks, because they know there’s a safety net to catch them if things go drastically wrong.

The following lessons and concepts have been learnt as a result of bailouts:

  • Banks are not willing to give loans to businesses, so central banks step in and help provide loans to protect the system.
  • Banks which are deemed as being “too important to fail” and on the brink of bankruptcy are provided with recapitalization by the government in exchange for shares.
  • The government steps in and becomes the owner of the failing bank (or other company) and later re-privatizes it by issuing out shares to the public.
  • The government prioritizes taxpayer dollars which are used for loans rather than paying dividends to investors.
  • Cuts are made in interest rates to lower lending rates and stimulate the economy.
bail_min
“To bail” or “to bail out” is to remove water from a boat so that it does not sink. The container is called “a bail”.

Examples of bailouts in recent history

Below is a list of some well-known bailouts in the United States:

1971 – Lockheed Corporation
1980 – Chrysler Corporation
2008 – Fannie Mae and Freddie Mac
2008 – Goldman Sachs Group, Inc. bailed out by the U.S. federal government and Berkshire Hathaway
2008 – Morgan Stanley
2008-2009 – American International Group, Inc. several times
2008 – General Motors Corporation and Chrysler LLC – although not technically a bailout.
2008 – UK bank rescue package
2008 – Citigroup Inc
2009 – Bank of America –  to help absorb losses incurred by its purchase of Merrill Lynch
2009 – Dubai and Dubai World bailed out by Abu Dhabi

Reasons against bailouts

American Republican Congressman Ron Paul wrote:

“In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned.”

“But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me…. It won’t work. It can’t work… It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians.”

Bailing out a major bank is no guarantee that it will start doing well any time soon. RBS (the Royal Bank of Scotland) was bailed out in 2008 by the UK taxpayer to the tune of £46 billion ($70 billion). From 2008 to May 2015, the bank posted £50 billion in losses. Many would say it is a classical example of a zombie bank.

The cost of a bailout

The World Bank stated that bailing out banks costs an average of 12.8% of GDP. It wrote:

“Governments and, thus ultimately taxpayers, have largely shouldered the direct costs of banking system collapses. These costs have been large: in our sample of 40 countries governments spent on average 12.8 percent of national GDP to clean up their financial systems.”

In November, 2014, the Governor of the Bank of England Mark Carney said “the days of banks are too big to fail are over.” He meant that there will be no more bailouts in future.

Video – Bank Bailouts Pros and Cons