Via James Furbush I see an old cartoon (ten years, some things do not change) from Calvin and Hobbes that explains how bailouts work (click on the picture below for a larger image).
This reminds me of the panel discussion at the Boston Fed conference I attended this week with the title "Will the Federal Reserve be able to serve as a lender of last resort in the next financial crisis". In the panel, Martin Feldstein, Simon Johnson, James Segel and Donald Kohn shared their views on the issue. The unanimous answer to the question was "no". With the introduction of the Dodd-Frank reform and the current political climate, it is impossible to imagine the Federal Reserve doing what they did in 2008 and 2009.
From a legal point of view, the Dodd-Frank reform modified the Federal Reserve Act in several ways. In particular, there was section 13(3) that allowed the Federal Reserve to do emergency lending to "individuals or corporations" other than banks. This was the section used for the money that went, for example, to AIG. That section has been modified and now there is no direct lending to an individual or a corporation other than a bank. It has to be part of a program or facility where the individual or corporation participates. So the flexibility is now more limited and it might take time to put such a program in place. In addition, credit cannot be extended to an organization that is failing, only to those that are short of liquidity. This is a good point but how can you tell whether it is a failure or shortage of liquidity. And, finally, many of these steps will require congressional approval. This is a key issue. Given the current political climate, it means that things will have to get much worse than last time before the congress ever approves any necessary funding.
Ideally you want to set conditions for crisis and bailouts never to happen. And part of what the Dodd-Frank legislation is doing goes in that direction. But you still need to think about events that will require the central bank to act as lender of last resort. And these events require flexibility but they also require transparency and accountability (in a democracy). But finding the balance between the two is not easy. The discussion in the panel gave me a clear impression that in the US the balance has now tilted too much in the other direction. By reducing the power of the federal reserve to act as a lender of last resort, we do not have the same ammunition as before to handle these crisis. I am all for avoiding bailouts that allow institutions and their managers to benefit from any upside and pass the downside loses to the taxpayers, but we need to be realistic and understand that in some occasions saving failing or illiquid institutions might be necessary.