The or a government offers money to a failing

The 2008 recession of USA
was one of the worst economic crises that America has ever faced since the
Great Depression of the 1930s. It was caused by the collapse of an 8
trillion-dollar housing bubble leading to millions of Americans losing their
homes and the closure of many large banks on wall street and insurance firms
like AIG. One such company which faced the blow of the great recession was
LEHMAN BROTHERS. Lehman Brothers was an investment banking firm and before
declaring its bankruptcy in 2008, it was the fourth-largest investment
bank in the United States behind Goldman Sachs, Morgan Stanley,
and Merrill Lynch, doing business in equity, investment banking and fixed
income sales and trading (especially U.S. Treasury Securities), investment
management, research, private equity and private banking. Lehman Brothers
was operational for 158 years from its founding in 1850 until 2008.

 

Before the filing of
bankruptcy by Lehman Brothers, the Treasury and Fed had gotten all the bankers
and tried to get a private sector solution for the mounting problem. They tried
to ‘bailout’ Lehman Brothers out of their financial problem. A ‘bailout’ is a
situation where-in an individual, a business or a government offers money to a
failing business to prevent the consequences that arise from the business’s
downfall. Bailouts can take place in forms of stocks, bonds, loans, stocks or
cash and may or may not require reimbursement. Bail outs are generally
accompanied by greater government oversee and regulations and the main reason
for a bailout is to support an industry that may be affecting millions of
people internationally and could be on the verge of bankruptcy due to prolonged
financial crises. 

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Bailouts have several
advantages and some of them are that they ensure the continued survival of the
entity being rescued under difficult economic circumstances and also a complete
collapse of the financial system can be avoided, when industries too big to
fail start to crumble. The government in such cases steps in to avoid the
insolvency of firms that are needed for the smooth functioning of the overall
markets. 

 

Bailouts also have some
disadvantages like anticipated bailouts encourage a moral hazard by allowing
not only promoters but also other stakeholders to take higher than recommended
risks in financial transactions. This happens because they start counting on a
bailout when things go wrong.

 

A new term which has been
proposed recently is ‘BAIL IN’. A bail-in is an alternative to bail-outs of
failing banks where investors take a loss rather than government and taxpayers.

Typically speaking, bailouts have been far more common than bail-ins, but in
the recent times, governments now require the investors and depositors in the
banks to take a loss before the tax payers.

 

Bail-ins and bail-outs
arise not out of choice but of of necessity. Deposit-holders and investors
in a troubled financial institution prefer keeping the firm solvent rather than
choosing an alternative, that is to lose the full value of their investments or
deposits if the bank goes under. Governments also prefer not to let a financial
institution go under, mainly because a bankruptcy on this scale increases
the situation of a systematic risk in the market.

Typically bail-ins was
resorted to in cases where a government bail-out is unlikely due to either (a)
the financial institution’s collapse is not likely to pose a systemic risk
because it does not fall into the “Too Big to Fail” category; or (b)
the government does not possess the financial resources necessary for a
bail-out because it is itself heavily indebted. 

Theoretically speaking,
bail-ins are preferred over bailouts because they preserve market discipline
without causing undue harm to the innocent people. Also, the bailout habit is
bad for growth of the economy. This is because bailouts encourage excessive
risk taking behaviour which ends up producing larger and longer lasting busts.