Since the Committee to Save the Banks first proposed using the funds from TARP to bailout the banks, I have pointed out bank bailouts are completely unnecessary.

Why?

The combination of deposit insurance and the central bank acting as lender of last resort means even an insolvent bank can continue in operation indefinitely.

Why is this true?

When a bank becomes insolvent (its liabilities exceed the value of its assets), deposit insurance makes the taxpayers the insolvent bank’s silent equity partner.

Let me explain why this is true and is the result of how our financial system is intentionally designed.

During the early 1930s, the Fed was reluctant to lend to banks experiencing a run.  It was reluctant to lend for fear of losing the money it lent.  The FDR Administration ended the risk of loss through the introduction of deposit insurance.

Funds lent by the central bank have first claim to the liquidated value of an insolvent bank’s assets.  This is done by pledging the bank’s assets to the central bank and the central bank lending an amount that is less than the value of the assets (the difference between the loan amount and the value of the asset is called a haircut).

Imagine an insolvent bank loses all of its unsecured funding.  It replaces this funding with borrowing from the central bank.  As a result, its two sources of funding are the central bank and insured deposits.  Both are stable sources and not prone to leaving the bank despite its insolvency.  Hence, an insolvent bank can continue operating indefinitely supporting the real economy until shutdown by the bank regulators.  It never needs to be bailed out!

Why would an investor pull their money out if it is insured against losses?  As shown by the US Savings & Loan in the mid to late 1980s, they don’t.

Why is this always true?  Another term for “deposit insurance” is the taxpayer.  As ultimately, it is the taxpayer that stands behind deposit insurance.  In the US, the Federal Deposit Insurance Corporation has the right to tap the US Treasury for billions in funding to cover losses it pays out making insured depositors whole.  A funding number that Congress could increase should the need arise.

The Dodd-Frank Act confirms bank bailouts are never necessary for the reasons laid out above.  It confirms this with its Ordinary Liquidation Authority (OLA).  Under OLA, financial regulators can access funding from the government while an insolvent bank is being wound down.

What is the difference between accessing funding from the government versus accessing funds from the central bank acting as a lender of last resort while an insolvent bank is being wound down?  From an insolvent bank’s perspective, NOTHING!

The Dodd-Frank Act claims OLA is something new and wonderful.  When in fact, the funding under OLA has been part of the US financial system since the 1930s.