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When the state steps in

A recent decision of the British government to take over the ailing Northern Rock Bank, has predictably raised a storm. Until September 2007, when its main sources of funding dried up owing to the turmoil in the global financial markets, Northern Rock was the country’s largest, high profile mortgage lender, although in hindsight it seems to have indulged in some reckless lending, very much like the global banks across the Atlantic. The loss of depositors’ confi dence caused a run on the bank, the first for a British bank since the 19th century. To prevent the run from spreading to other banks, the government intervened aggressively by pumping in a colossal amount of tax-payers’ money to keep the bank afloat. After attempts to find a suitable private sector buyer failed, the government has, for all practical purposes, nationalised the bank, although for the record the new arrangement is called “temporary public ownership.” The move has invited a great deal of criticism, mainly on the grounds that it might encourage banks adopting imprudent practices to take additional, unacceptable risks. This issue of moral hazard came into sharp focus recently in the aftermath of the sub-prime crisis that saw the release of huge sums of money into the system by central banks and an unprecedented cut in interest rates in the United States.

The nationalisation of a bank might appear an extreme step even in a context where macroeconomic policies are calibrated to the needs of specific sectors. Even so, it is not without precedents. Just a week earlier, the German government stepped in to save a small bank from collapsing. In the U.S., the government has a tradition of bailing out large firms and institutions using public money. The savings and loans associations were rescued in the 1970s and a large derivatives firm more recently. Japan has not been averse to extending public ownership to troubled institutions for short periods. In India, where there is basically no ideological opposition to government intervention, the recapitalisation and relaunch of the UTI in 2002 has been a seminal event. All nationalised banks were provided with additional capital in the reform era. One of them, Indian Bank, survived a serious financial crisis only because it was government-owned, prompting its depositors to stay with it in troubled times. The key task in India is to ensure that public money used in the bail-out packages is well spent.

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