In 2008, I started making the point banks are designed to protect the real economy during a financial crisis (as oppose to the real economy being used to protect the banks).  Banks protect the real economy by absorbing the losses in the financial system.

I received significant pushback from the Economics profession.  They kept repeating if banks take losses they will become insolvent and will have to be closed/nationalized immediately.

This statement contains three falsehoods:

1. Whether banks recognize or don’t recognize their losses they are insolvent as the market value of their assets is less than the book value of their liabilities;
2. A bank only needs to be closed if it is not viable after recognizing its losses.  A viable bank can generate earnings to rebuild its book capital either through retained earnings or through issuance of new equity;
3. An insolvent bank doesn’t need to be closed/nationalized immediately.  Because of deposit insurance and a central bank lender of last resort, an insolvent bank can remain open and continue to make loans and provide payment services indefinitely.  As a result, a determination of a bank’s viability doesn’t have to be made during the acute phase of a financial crisis, but can be delayed.

Apparently, the EU agrees with me.  They have been making great strides on expanding EU deposit insurance.  And now, the ECB has come out and said it could lend to insolvent banks that are not in liquidation.

Effectively, the EU is embracing using the banks to protect the real economy during a financial crisis.