Preventing German Banks Failures: Federalism and Decisions to Save Troubled Banks
25 Pages Posted: 4 Aug 2014 Last revised: 3 Jun 2015
Date Written: 2015
Letting a bank fail is a government decision. Governments have several tools to forestall bank failures, such as regulatory forbearance, liquidity support, and recapitalization. We examine government decisions to support troubled banks. We begin with the simple assumption that governments are more likely to prevent failures of systemically important institutions. Our contribution is the examination of how federalism can affect decisions to classify banks as systemically important. Whether a bank is viewed by politicians as ‘systemically important’ varies based on how its failure would affect supporters of the government supervising and responsible for closing it. Because of this, how a federation is designed has a strong influence on which banks are given public assistance. In federations where the top level of government is solely responsible for banks, ceteris paribus there will be fewer systemically important institutions and so more banks will be allowed to fail. In federations where lower levels are responsible, there will be relatively more systemically important institutions and governments will allow fewer failures. We use this approach to understand considerable recent government support for failing banks in the German federation. Our findings are not only of interest to those working on German banking, but also those wanting to understand lobbying to create and likely outcomes in the new European Banking Union, as well as other federations.
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