Why Bailouts Are Bad

Todd Zywicki reviews Financing Failure: A Century of Bailouts by Vern McKinley and makes the following observation:

What is a “bailout” and why are bailouts bad? McKinley argues that a “bailout” of an insolvent institution is the corruption of an arguably sound idea, going back to the Nineteenth-century British economist Walter Bagehot, that a central bank may be a useful institution to preserve the soundness of the financial system in a time of panic. But Bagehot’s core distinction was between what today would be called illiquid versus insolvent institutions. It is crucially important that the distinction be preserved—saving an improvident and mismanaged failed institution from its day of reckoning undermines incentives for prudent operation, weakens public confidence in the financial system by propping up failed institutions, provides unfair economic advantages to the disadvantage of responsible banks, risks taxpayer dollars, and typically produces larger losses in the end than would have otherwise been the case (as evidenced most strongly by the savings and loan crisis of the 1980s).

The real concern is to protect the operations of solvent institutions confronting a bank run because of loss of public confidence in the banking system and the uncertainty whether a particular bank is also insolvent. Similarly, the purpose of deposit insurance is to provide confidence that depositors will be made whole in the event of a failure, thereby relieving the ordinary depositor of the risk of leaving their deposits in a particular institution.

The role of a central bank, therefore, is not to provide capital to insolvent banks during a time of crisis, but to provide capital to solvent but illiquid banks. So—to state the glaringly obvious point widely ignored throughout the financial crisis—if Citibank is insolvent, the Federal Reserve should not lend to Citibank to prop it up. Instead, it should lend to banks other than Citibank that are solvent, but which could suffer a confidence-induced bank run if Citibank were to fail. A bailout occurs, therefore, when the Federal Reserve or Treasury provides funds to insolvent institutions, thereby propping them up, with all the negative consequences that entails. 

As McKinley demonstrates, this failure to remain focused on the central justification for government intervention in crisis periods has led to increasing numbers and cost of bailouts in each succeeding financial crisis.