How do you force a government to bail out an insolvent bank?

In a free market economy, usually the government would let the bank go under (and bail out the depositors) because government bailouts lead to moral hazards.<br><br>But what if the bank in question is essential to the functioning of the economy, so the government cannot afford to let it go under? Then it has to bail it out. But how does the government afford to do it? It would appear that the calculation here is always underfunded.<br><br>Let’s consider a very stylized example:<br><br>- A government tax revenue is 100<br>- A bank has assets worth 1000 but liabilities worth 1100<br>- The bank is so important that the government cannot afford to let it go under<br><br>If the bank is insolvent, the government will have to bail it out by paying off the liabilities of 1100 with its tax revenue of 100. But how does the government make up the difference of 1000? It needs to generate more tax revenue, but how?<br><br>Tax all of the citizens by 1000, so the government will get an extra 1000?<br><br>Wrong, because in this example the citizens also have liabilities of 1100 (they lent money to the bank). If the tax rate is 1000, citizens will have to pay tax of 1000 and they won’t have any money left to pay their debt of 1100!<br><br>So citizens will also become insolvent, so how do the banks get their money back? They can’t!<br><br>So the government is still insolvent. It has assets worth 1100 (the 1000 it got from the citizens plus the 100 it got from tax revenue) but liabilities worth 1100, which is the debt it owes to the citizens.<br><br>In essence, the government cannot bail out an insolvent bank. The government and the bank and the citizens are all insolvent, because they lent each other money and they collectively owe more money than they have!<br><br>So if the bank is so important that the government cannot afford to let it go under, then the government should bail it out. But the government cannot bail it out because it is broke (and will be broke forever since it can never generate enough tax revenue).<br><br>This is a huge problem, because it means that governments cannot bail out banks that are essential to the functioning of the economy. So what do governments do in this case?