Discuss whether providing substantial government financial support to banks is the best policy response during a financial crisis

Edexcel A-Level Economics Paper 2 June 2019 Extract

Discuss whether providing substantial government financial support to banks is the best policy response during a financial crisis. (15 marks)

1. On the one hand, it is best that the government provide financial support to banks during a financial crisis to prevent systemic risk and cause a demand-side shock on the economy.
2. Systemic risk means that financial markets are strongly connected so the failure of one bank could cause other banks to fail.
3. During a financial crisis there is a risk of a bank run, where consumers lose confidence and withdraw their money.
4. This could lead to a liquidity crisis, and could cause bankruptcy.
5. To prevent this, the government may need to provide financial support to banks.
6. This would prevent a dip in consumer confidence and business confidence, which would cause a negative multiplier effect and a recession, as seen in 2008.
7. The benefit of this is that unemployment doesn't increase as rapidly, which means the government would not see a huge decrease in tax revenue.
8. The extract mentions that the government ‘recovered every penny of its investment in Lloyds’

1. However, the problem with the government financially supporting banks is that it causes moral hazard.
2. In the future, financial institutions may expect the government or the central bank to bail them out if there is a risk of financial market failure.
3. If firms expect this, they may act in a more risky way, making the failure more likely.
4. Additionally, there is a huge cost of supporting financial institutions.
5. For example, the extract mentions the £65bn bailout of RBS and LBG.
6. This would lead to an increase in the budget deficit and also national debt levels, which means higher taxes and lower government spending for future generations.

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