The decision to bail out banks en masse in 2009 was widely adopted yet far from uncontroversial. Research from UCL explores whether AI can help governments to decide whether to bail out a bank in crisis or not.

The researchers developed an AI tool that assesses whether such an approach will yield a good return for taxpayers, while also providing a recommendation for the level of investment in the bank and whether a bailout is a good idea or not.

Bailed out

The tool was tested using data from the European Banking Authority, with 35 distinct financial institutions assessed according to their importance to the global financial system.

“Government bank bailouts are complex decisions that have financial, social and political implications,” the authors explain. “We believe the AI approach we have developed can be an important tool for governments, helping officials assess specifically financial implications—this means checking if a bailout is in the best interest of taxpayers, or whether it would be better value for money to let the bank fail.”

Bailing out a bank incurs short-term costs because the government investment inevitably increases the equity in the bank and therefore reduces its risk of defaulting. This short-term cost is justified to the taxpayer because the long-term costs of bank defaults would be more harmful.

Smarter decision making

They showed in one case study that a government bailout would only be the right course of action if the ultimate stakes taken were greater than a critical threshold value. If the percentage loss went above this threshold then the optimal policy would change dramatically.

The research also showed that bailouts tend to be more effective when the network is in a greater state of distress and the crisis was going on for longer. It was also the right course of action when banks were heavily exposed to each other.

The researchers also found that, once a bank had received a bailout, the best strategy for taxpayers was if the government continued to invest in that bank to prevent default. This could lead to a lack of incentive for the rescued bank to guard against risk, potentially increasing risk-taking.

They hope that their tool can be not only be useful in determining the best course of action going forward, but also to assess whether previous actions were right or not.

“Governments and banking authorities can also use our approach to retrospectively review past crises and gain valuable learnings to inform future actions,” they conclude. “One could, for example, review the UK government bailout of the Royal Bank of Scotland (RBS) during the financial crisis of 2007-9 and reflect on how this could potentially be improved (from a financial standpoint) in the future in order to primarily benefit taxpayers.”