As the financial crisis accelerated in late 2008, financial regulators expressed their age-old fear banks might be forced to sell assets at fire sale prices.  Was this expressed fear the result of a flaw in the design of the financial system or was it purely political to put pressure on lawmakers to bailout the banks?

It was not a design flaw.

In fact, the financial system design explicitly put in place a mechanism so banks wouldn’t be forced to sell their assets in a fire sale to meet depositors requests for return of their money.  This mechanism is called a lender of last resort.  In the US, the Fed is the lender of last resort.

As Walter Bagehot defined this lender of last resort in the 1870s, its role was to lend freely to solvent banks at high rates of interest against good collateral.  Please note, the focus is on the question of whether the collateral is good (where good means the collateral can generate the cash necessary to repay the lender of last resort loan) and not what is the current market price for the collateral.

The adoption of deposit insurance changed this definition of the lender of last resort role.  Rather than limit lending to solvent banks, the lender of last resort could also lend to insolvent banks that were still viable.  A viable bank is one where after recognizing all the losses on its exposures it can still generate positive pre-banker bonus earnings (I use pre-banker bonus earnings because a bank with a loan from the lender of last resort or with book capital levels below regulatory minimums shouldn’t be paying bonuses).

But what about non-viable banks that don’t qualify for a loan from the lender of last resort?  Clearly, these are banks that should be shutdown.

But if the non-viable banks’ assets are sold at fire sale prices, won’t the deposit insurance fund and hence the taxpayers suffer losses?  By design, the deposit insurance fund can incur losses, but the taxpayers doesn’t.  To rebuild its fund after recognizing any losses from closing a non-viable bank, the deposit insurance fund increases the premium it charges to the surviving banks.  It is the remaining banks rather than the taxpayers who effectively are saddled with the losses the deposit insurance fund incurs.

This arrangement makes it very important banks provide transparency.

Lending banks know it is highly unlikely if a fire sale takes place that they will be repaid for an unsecured loan to a non-viable bank.  This is a feature of, rather than a bug in, the financial system design.  It gives lending banks an incentive to use their expertise and the disclosed information to assess the viability of the borrowing bank.  It gives lending banks an incentive to constantly monitor and adjust their total exposure to borrowing banks based on this assessment.