It is instead the role of government to underwrite the soundness of the financial system. This is generally considered to include assuming the risk for depositors although there is debate as to the extent to which this should best occur (first $10,000 of a depositor’s funds, $100,000, unlimited?)

Bank shareholder funds have never been government guaranteed and are subject to diminution or even disappearance, the same as with any other joint stock company.

Financial institutions are supposed to shoulder their own risk of wholesale lending to banks (e.g, buying bank bonds, certificates of deposit, bank-endorsed commercial paper and the like). Each institution maintains an exposure limit to each counter-party, such that if that bank reneges on its debt, the loss is manageable.

What we had last year following the unravelling of sub-prime debt and Lehman Brothers collapse was a systemic failure, where nobody knew anymore what their risks were and market activity essentially froze.

The way this has all been playing out has been by the seat of the pants and very messy. After the shouting dies down there will presumably be better rules developed as to what to do if a large bank or other financial institution becomes insolvent.

Well, that’s the choice: credit conditions imposed by governmental fiat that may or may not be honoured according to the contingencies of government, or credit conditions that may or may not be honoured according to the solvency of the private debtor.

What does the limited liability of the debtor (or lack of) have to do with who the creditor is?

I don’t know if shareholders of financial instituions should ask for any greater or lesser rate of return as any government bailout should really aimed to do little more than preserve the banks survival not preserve some significant level of shareholder equity as well. A bank shareholder should invest in the full knowledge that if the bank is poorly run they stand to own completely worthless shares even if the bank itself survives in some sort of quasi administration form for a period.

Almost universally, the market determines the rate of return on capital, via p/e ratios, etc. Australian banks have usually paid approx 5% dividends. It’ll be interesting to see whether this figure undergoes any major change in the medium term in light of the current crisis.

Kingsley is correct when he says that shareholders in selected banks in the US have been expropriated by the Bush administration. All other things being equal, that risk may attract a premium when investors decide whether or not to invest in US banks.

Moreover, perhaps increased consciousness of the volatility of world finance, in which circumstances even the largest banks may find themselves severely embarrassed by events utterly beyond their control may also result in investors in banks demanding a higher rate of return on their shares.

I think Katz is right to raise the special importance of financial institutions. There maybe alternatve financing means available, private mortgages for instance but clearly if say 90% of banks failed the probabilities of a genuine economic depression are extremely high whilst losing 90% of your auto manufacturers would likely only result in an exacerbated recession. Given the misery of a depression this otherwise fiscal conservative would prefer Govt move to ensure we suffer a recession instead of a full blown depression. Fiscal conservatives do need to remember that financial hardship can cause marriage breakups which may involve children and indeed suicides.

I don’t know if shareholders of financial instituions should ask for any greater or lesser rate of return as any government bailout should really aimed to do little more than preserve the banks survival not preserve some significant level of shareholder equity as well. A bank shareholder should invest in the full knowledge that if the bank is poorly run they stand to own completely worthless shares even if the bank itself survives in some sort of quasi administration form for a period.

One other issue I think needs examination is the issue of moral hazard. Financial rescues are resented and opposed because of moral hazard. That’s fair enough. However I think if the decision makers suffer the apprpriate penalties, personal bankruptcy, etc then I don’t see much incentive for an intelligent CEO to recklessly engage in poor lending practices. Nothing can really be done about the unintelligent ones.
I don’t see much merit in punishing Mr and Mrs Penioner for putting their term deposit with a household name financial instituion with supposed Govt backing.

One other possible option to minimise the need for Govt to bailout financial institutions from time to time is to raise capital adequacy ratios to levels that make financial failure close to impossible and likewise debt to equity ratios that lenders are allowed to adopt for customers. ie a bank can only lend say 60% of the value of a house not 80% or higher with mortgage insurance. That of course does massively de-leverage the economy and until it finds it new equilibrium will be quite “deflationary”. It would be interesting to model these things out as it would mean face value a new homebuyer has to save up a far larger deposit before they can become a home owner yet we would also find with far less credit available that home prices are far more affordable. Once the changes had worked there way through could we get a win/win where overall home affordability is still very achievable but the home owner owns a far larger portion of their home? Interestingly think we would generally describe someone who saves up a 40% deposit for their home as fiscally conservative but laws demanding it maybe described as anti-market and socialist in nature.

Unlike that other credit that people always pay back out of the goodness of their hearts?

Well, that’s the choice: credit conditions imposed by governmental fiat that may or may not be honoured according to the contingencies of government, or credit conditions that may or may not be honoured according to the solvency of the private debtor.

What we have at the moment is a puppet show where the government underwrites the debts of selected banks and other selected lending institutions on the pretence that private capital markets are viable.

Again, you mistake me for a defender of market finance. I’m simply pointing out how much has to be torn up and thrown out were the US or Australia to attempt to adopt nationalised finance.

AKA Fiat credit ultimately backed up by bayonet and martial law.

Unlike that other credit that people always pay back out of the goodness of their hearts?

Nationalised banking for a start.

AKA Fiat credit ultimately backed up by bayonet and martial law.

Don’t misunderstand me. Such systems have worked (for a while) in the past. But they are impossible to square with the US Constitution or for that matter probably with the Australian Constitution.

So if it is to be bank nationalisation, constitutions would have to change.

Understanding the role of the state in a capitalist society helps us to see why, when a government bails them out with public money, the bankers do not see this as the start of socialism.

If it’s the government’s role to assume the risk of the banks, then it was a massive screw up to surrender control of the risk through insufficient regulation.