Failing Banks: A Question of Destruction

Danièle Nouy, Banks and Schumpeter

The global financial crisis has left governments, academics and the public with much consternation surrounding the economy, with particular concern on the banking industry. Many have voiced their angst that taxpayers’ money is being thrown at these banks who appear to have caused a great amount of destruction in our economy. However, we must remember that a strong financial system is a vital component of the modern world. That said, the banking system must address its shortcomings to regain credibility. This blog will take a look at what is being done to progress the system and assess whether – to exude real change – some creative destruction is required.

Let Weak Banks Fail

In the last week, Danièle Nouy, the new chief banking regulator of the ECB, stated that weak banks should be allowed to fail. The implication of this statement largely goes against government interventions of 2007/08 where many large banks that faced massive losses and/or imminent failure were subsequently bailed out.

The ECB’s statement shares some inferences with the theory of “Creative Destruction”, a term coined by the Austrian economist, Joseph Schumpeter, in his 1942 book, “Capitalism, Socialism and Democracy”. This phrase neatly describes a fundamental characteristic of capitalist economies: out with the old and in with the new. 

Abiding by pure Schumpeterian assessment of capitalist markets, these failing banks should be allowed to meet their demise. However, many would retort that this would be more likely to cause destructive destruction. Miss Nouy also conceded that “it’s not the best moment in the middle of the crisis to change the rules”. That said, the ECB and many others would agree that, in the long run, these rules must be changed; stricter regulations need to apply and more accountability must be incurred.

What Next?

The fact that banks are being bailed out so frequently suggests there needs to be major restructuring to the current model; there is capacity for creative destruction. So far, progress is centered on regulation and banking reform, but there is early evidence to suggest the answer lies in a greater form of change.