Why do politicians and bank regulators have such a hard time giving up bailing out banks?

Fear.

Fear of contagion.  Fear that allowing an interconnected bank to fail will bring down several other banks and damage the real economy.

 

When looked at through this lens, bailouts always make sense.

But is this the right lens for politicians and bank regulators to look at bailouts through?

No.  It is not the right lens because it ignores our financial system is designed so bailouts are never necessary.

There are two features in the financial system’s design that make bank bailouts unnecessary.

The first feature is deposit insurance.  By definition, a bank is insolvent when the market value of its assets is less than the book value of its liabilities.  What follows from this definition is when a bank is insolvent deposit insurance makes the taxpayers the bank’s silent equity partner.

Why is this so?

Without deposit insurance (and a government guarantee for any creditors not covered by deposit insurance), depositors would run down to the bank to withdraw their money.  It is this liquidity event that would force the closure of the insolvent bank.

However, because there is deposit insurance, depositors (and a government guarantee for creditors) don’t withdraw their funds and the bank is in a position where it can keep operating.

The fact an insolvent bank can keep operating for an indefinite period of time doesn’t mean it should be allowed to keep operating.  The only insolvent banks that should be allowed to keep operating are those that are viable.  A viable bank is one where after recognition of all the losses on its assets it can generate positive earnings.

The second feature of our financial system assists the bank regulators in determining if an insolvent bank is viable or not.  The second feature is transparency.  Investors know that in exchange for disclosure of all the information they need to make a fully informed investment decision they are responsible for all losses on their investments.  This gives investors an incentive to assess the risk of any investment and limit their exposure to that investment to what they can afford to lose.

Naturally, investors are only going to want to invest in an insolvent bank if it is viable.  If investors aren’t willing to invest, bank regulators should close the insolvent bank.

Let’s return to the fear of contagion for a second.  If investors, and this includes banks, limit their exposures to what they can afford to lose, why does this fear of contagion exist?

Fear of contagion exists because bank regulators know banks are black boxes.  The banks’ lack of transparency makes it impossible for investors to assess the risk they are taking.  As a result, investors can have more exposure than they can afford to lose.  For example, Bank A can have so much exposure to insolvent Bank B that the failure of Bank B makes Bank A insolvent.  By definition, this is what contagion risk is all about.

So how do we eliminate the fear of contagion and therefore politician and bank regulator addiction to bank bailouts?

Require the banks to provide transparency.

The Transparency Label Initiative is doing this.  It only awards a label to banks that provide sufficient disclosure so an investor could know what they own.  The lack of a label is the Initiative’s way of saying buying any non-government guaranteed bank securities is the equivalent of blindly betting.

Are portfolio managers and investment companies telling investors who give them their money to manage that they are blindly gambling with this money?