The ‘Bailout’ That Isn’t

Rescuing Banks is Not a Violation of Free Market Ideology


The media has fallen in love with that word. It meshes so well with the hydrological metaphors which pervade the finance world. We’re always pumping this, or trickling down that, or watching a rising tide lift all boats. It’s no surprise that we use water to describe monetary affairs — it was, after all, the economists who started it in the first place with all their talk about “liquidity.”

But the image of a bailout, with the U.S. taxpayer rushing to the aid of a sinking bank to help keep it afloat, is not an accurate one. This is not socialism — nor is it a gift to banks or a burden upon U.S. taxpayers. It is the activation of a failsafe that has been present in our economy for decades, a failsafe that is perfectly in accordance with laissez-faire ideals and which belongs as a permanent component in any free market system.

At first glance, a market for money is no different from a market for say, hot dogs. There is a demand (borrowers), a supply (lenders), and the interaction between the two determines an equilibrium price (the interest rate).

The difference that justifies the different treatment of hot dog and money markets is the need for intermediaries. As a short-hand I will collectively refer to financial intermediaries as “banks,” but it is important to note that the term extends to any institution that collects deposits and invests them, from credit unions to bank holding companies.

Having lenders and borrowers seek each other out on an individual basis would require an immense duplication of effort — a lender looking to loan out $1,000 for three years would have to find a borrower looking for the exact converse. Such a process would be immensely inefficient. To avoid this inefficiency, banks have been created to provide centralized information gathering and decision making. By having lenders and borrowers solicit their offers and requests at a centralized bank, it becomes much easier to match the two together.

The intermediary’s role is (and should be) purely profit-seeking. It takes deposits, seeks out the areas of highest return, and invests in them.

However, there are two problems that a financial institution can encounter, and here is where the trouble begins. The first problem is one very similar to a hot dog maker that does a poor job of producing hot dogs: a bank may make bad decisions regarding where it should invest. The second problem is that depositors may demand their money back from the bank in unexpectedly large amounts. Both scenarios manifest in the same manner: the bank is unable to cover deposit demand, but the difference in the reasons (the first bank’s assets are bad and the second bank has good assets that simply can’t be liquidated fast enough) means that the banks in the two scenarios should have different outcomes. The first problem is one of balance sheet insolvency, the second one of cash flow insolvency. For simplicity I will refer to them as “a solvency problem” and “a liquidity problem” respectively.

In a free market, insolvent banks should be allowed to fail. They made bad bets and must not be allowed to have someone else pay their tab. But illiquid banks, because they still have assets greater than their liabilities, should be able to smooth out their liquidity problem by borrowing from other lenders to cover their short term deposit demand.

In practice, it is difficult for banks to perform this smoothing function purely by borrowing from other banks. A pernicious feedback loop exists: a bank run is a self-fulfilling prophecy. As the probability of bank failure increases, more depositors seek to withdraw their money and fewer lenders are willing to loan short term funds to the bank.

For this reason, the government has been positioned as a lender of last resort: should a solvent but illiquid bank be unable to smooth over its deposit demand by borrowing from other private lenders, the government is committed to intervene and lend money to the troubled bank.

Because the federal government has a duty to act as a lender of last resort to illiquid banks yet avoid lending to insolvent banks, regulation and requirements are needed. In practice, this amounts to two measures: a regulatory system which serves to gather information and help federal decision makers distinguish between illiquid and insolvent banks (and prevent insolvent banks from doubling down on their bets and becoming even more insolvent), and a reserve ratio that gives regulators a margin of error in performing their duties.

The reserve ratio, in short, is a requirement that a certain fraction of a bank’s deposits be kept on hand as a reserve. It serves to mitigate the effects of insolvency (since depositors can be paid back with the reserve), and cover unexpected increases in deposit demand.

The higher the reserve ratio however, the greater the inefficiency in the system. If 20 percent of a depositor’s funds must remain idle in the bank, the rate of return they receive will be 20 percent lower than what it could have been. The ideal reserve ratio is zero, where for every dollar lent to the bank it has one dollar to lend out. In practice, the United States maintains a reserve ratio of around 20 percent, reflecting the necessary trade-off between efficiency and regulatory needs.

The subprime housing crisis was, in effect, a series of bad investments. Banks extended mortgages to millions of shaky borrowers, betting that the price of houses would continue to rise. When they didn’t, the banks suffered large losses.

These losses have created a liquidity problem across the financial industry. Not only is it a problem of assets not paying back their expected revenue streams (thus straining the banks’ ability to return deposits on time), but because not all of the bad mortgages have revealed themselves, banks are forced to maintain greater reserves, to protect against the possibility that a greater than expected number of their assets will turn up bad. Thus, the troubles are multiplied; some of the banks clinging to their liquidity will ultimately not need it. If the uncertainty could be removed, it would be possible to return to normalcy.

This is where the “bailout” comes in.

Both the Federal Reserve and the Treasury Department view the central problem facing the financial markets as one of illiquidity, not insolvency. Given a long enough time horizon, banks would be able to pay off their liabilities. Therefore, they’ve put together a plan to purchase the troubled assets of banks. The hope is two-fold: to recapitalize banks (the assets would be bought with liquid cash), and remove the uncertainty that is paralyzing the markets. Other approaches have their pros and cons — for example, investing in bank equity would better recapitalize banks, but not remove the uncertainty. But the “bailout” is not a lump-sum transfer to banks; it is not a socialization of losses. If a nominal dollar’s worth of mortgage assets is worth 80 cents, the Treasury Department could purchase it for as much as a dollar or as little as 40 cents. With a $700 billion dollar buy, the tax payers could lose as much as $140 billion or gain as much as $700 billion.

We can dispute the details of the rescue plan: how the purchases should be overseen, whether it is best to recapitalize banks through the purchase of equities instead of assets, whether we should aim for maximum taxpayer gain (buying low) versus maximum recapitalization (buying high), or some trade-off in between … but the fact that we are buying is not a repudiation of the free market. We still have good reason to believe that private institutions, even with their need for reserve requirements, are still better at generating higher rates of return than public institutions.

Regulatory reform could have prevented a small fraction of the mess. Equalizing reserve requirements across institutions, centralizing oversight authority in a single institution like the Federal Reserve, passing the Federal Housing Regulatory Reform Act of 2005 (sponsored by McCain but opposed by Obama) … all of these might have taken the edge off of the crisis, but none of them would have prevented the fundamental problem: financiers misjudging the worth of homes. In the future we should enact reform, but not expect it to correct for the fact that sometimes, even the best and brightest can get it wrong.

On Monday, the House of Representatives failed to pass a rescue bill that had been proposed by the Treasury Department, and modified by House and Senate leadership. House Republicans are the direct cause of the failure, having voted against the bill 133-65. But speaker Nancy Pelosi also deserves much of the blame: shortly before the vote was cast, in what should have been a speech emphasizing the legislation’s strength and necessity, Madam Pelosi characterized the bill as the death knell of free market capitalism and a repudiation of Republican ideals.

As she spoke ominously of the upcoming election, she might as well have pounded her shoe against the table and told Republicans, “With this bill, we will bury you.” Unsurprisingly, the Republicans who voted against the bill were, nearly to a man, the list of Republicans facing tight races this November.

The important thing now is to pass an asset relief bill. The longer the liquidity crunch continues, the longer the real economy (as opposed to the financial one) will be left without needed investment, and the more severe the losses to economic growth will be. The faux-outrage from politicians over executive pay and free market hypocrisy is an unnecessary politicization of a needed solution.

The media, content to portray the rescue bill as a Faustian bargain between banks and tax payers, has been delinquent in its task of educating voters—until the man on the street properly appreciates the nature of the financial rescue and recognizes it not as special interest politics but a free market operation, politics will continue to find a way to interfere with the government’s response. It is time to get past the blame game and fulfill our role as lender of last resort.

Keith Yost is a graduate student in the Department of Nuclear Science and Engineering and the Engineering Systems Division.