With next week’s bailout of the US financial system comes the inevitable complaints by those who are angry that taxpayers will be footing the bill. A bailout will cost less than the alternative. Let me explain through a simplified example. The numbers are representative only:

For every $100 a bank might loan or invest, it typically will have funded only $7 of that figure via shareholders equity.* What that means in plain English is that banks are borrowing most (93%) of the money that they use to lend or invest.

If the bank makes too many bad loans & investments, it is the bank’s creditors who will lose — after the $7 in equity is wiped out. It’s simple math. And who are the creditors?

YOU! (if you have any US dollar deposits, that is.)

You are the creditor by virtue of the fact that you deposit money with banks. The bank then takes that money and lends it other people, including (maybe) you. The bulk of the banking system’s creditors are depositsΦ by people and corporations.

Given the lack of liquidity in financial markets, many banks do not have enough cash to meet creditors’ demands. What’s more, with doomsday predictions as to the value of banks’ loans/investments, there does not appear to be enough of an equity cushion to absorb the losses that would be incurred — even if those assets could be sold! So it’s you — the depositor — who is at risk of absorbing these losses.

But things can get worse if the government does not keep the financial system functioning. Imagine a world in which you woke up tomorrow and found that you could not withdraw your money from your bank. How would you buy your double latte? Because of the inter connectivity of the financial system, asset values would fall further as your bank sold off assets so that you could buy your lattes. Other banks would then have to write down the value off their assets. Other banks would fail. And so on. And so on. In a system without a functioning banking system, asset prices fall well below fair value. Imagine the panic that would ensue: people hiding money under mattresses, cats marrying dogs, republicans endorsing gun control — Armageddon.

Can you imagine how things might get worse than they might otherwise get — if the government (i.e. the taxpayer) did not come in to “rescue” the system?

This is Banking Crisis Management 101.^

Either way, you pay. But in one scenario you pay by losing your deposits. And in the other scenario, you pay as a taxpayer. But in the second scenario, the bill should be less than it would otherwise have been.

But even better: because the bill is being funded by government debt, it won’t be you who pays it off. It’ll be your kids.

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*Investment banks have much less equity for that same $100.

ΦBy “deposits” I mean all borrowing of the banks: customer/corporate deposits, short-term paper, bonds, etc.

^Note that it’s important in the rescue plan that the government does not overly protect shareholders of the banks. Shareholders should lose everything before the government (i.e. the taxpayer) comes in. But the system must not be allowed to fail.

UPDATE: As details emerge about the bailout over the weekend, there’s increasing negativity about the plan. Paul Krugman has a good piece in the NY Times. It appears that shareholders may be getting off the hook. This is plain wrong. It rewards the idiot bankers who created this problem in the first place. Shareholders do not need to survive in order for the banking system to work. Aleph blog sums it up here as he calls on his readers to oppose the plan. Key point:

What we don’t want to do is provide a place for companies to dump lousy assets at inflated prices. Instead, a new RTC should be a last resort place that the assets of failed companies go to until they are disposed of. Common and preferred equity should be wiped out, and bondholders should take haircuts. New loans should be senior to all old loans, similar to the situation with AIG.