The reason that the State felt it necessary to step in and rescue RBS was that it feared a systemic failure, i.e. that the bank was so big that if it went under it would take others down, create a mass run on the system as depositors raced to get their money out, and cause a collapse in the financial system as a whole. The ramifications of such a collapse are simply terrifying. So when the next big bank goes under should the State intervene again? The simple answer is yes, but only until we have changed the system upon which investment banking relies.
Banks and investment houses deal in a myriad of complex instruments called derivatives. There are scores of these things out there, some of which require an astonishing level of mathematic understanding. They are designed to maximize profit, but with huge profit potential there comes, alas, huge risk. When they blow, they tend to blow big. They do so because they blow at the worst time possible (perhaps because the banks all have similar looking portfolios) and there is no liquidity for the losses to be crystalized and the books squared, and the losses can blow exponentially. Bank A is unable to meet his obligations to Bank B resulting in a draw down in both banks balance sheets, and credit worthiness; and so it ripples outward triggering stop losses along the way in other asset classes within the banks. If no other bank can step in to rescue Bank A the whole system can fall like dominoes. So the State steps in.
The solution is quite simple: reduce the bilateral risk between banks A and B. This means that Bank B’s chances of survival are higher, and the risk to the system is reduced – never eliminated, of course, just reduced. The bilateral trades are known as Over-the-Counter or OTC trades. Bank A phones Bank B agree on the trade and after checking each other’s’ credit, the bargain is booked. Herein lies the problems at the centre of investment banking, the trade is reliant on the other bank being able to make good or settle the trade at its expiry date (some trades have maturity dates well into the future, I have traded a derivative with 5 years to go until it settles), so once one of the banks gets into difficulty the trade is in jeopardy. Furthermore each trade will generate other trades as the dealer looks to mitigate the risks attached to the original trade, and this can happen a multitude of times as the risks attached to trade #1 change over the passage of time and the motion of the markets. So the risk spawns yet more bilateral risk. Of concern too is the fact that none of these trades are exposed to open market scrutiny, and in most cases the individual banks will value the trade, and therefore their own balance sheets (I will leave that to you as to where that can lead). If all of the trades are subject to a multilateral risk sharing and exposed to public price scrutiny the issues begin to subside. And it is done in many markets already, run the trades through an exchange.
Exchanges, such as the Chicago Mercantile Exchange, step in-between our two banks and act as the counterparty. This minimizes the risk of the dominoes falling. The Exchange is owned by its members and so the risk attached to Bank A is spread across the entire membership, so if it fails it only takes with it a tiny piece of Bank B. As the exchange is the counterparty it has an embedded interest in ensuring that the valuation of the traded instrument is correct, and conducts an end-of-day survey to accurately value the trade, and stops any funny business. The exchange also demands that sufficient collateral is available and posted by both banks to ensure that they have enough money to keep up their end of the bargain. In other words, the market polices and enforces the banks. If either bank is incapable of posting collateral the trades are wound down until they are back within their trading limits, and if necessary the exchange can step in and take the whole portfolio away and spread amongst the members. This creates an orderly system that would allow for banks to fail, although the nature of how the exchanges operate ought to make the failure of banks less likely as there are plenty of early warning systems in place via the independent and public portfolio valuation.
I accept that the system can never be perfect, but forcing all the market participants to clear their trades in this way will certainly help, and allow bad banks to go bust.