Matthew Richardson and Nouriel Roubini have an op-ed on the stress tests in the WSJ. It makes a number of good points, but this one is particularly important:

“Stress tests aside, it is highly likely that some of these large banks will be insolvent, given the various estimates of aggregate losses. The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors. This is fair: Metaphorically speaking, these are the guys who served alcohol to the banks just before they took off down the highway.

And we shouldn’t hear one more time from a government official, “if only we had the authority to act . . .”

We were sympathetic to this argument on March 16, 2008 when Bear Stearns ran aground; much less sympathetic on Sept. 15 and 16, 2008 when Lehman and A.I.G. collapsed; and now downright irritated seven months later. Is there anything more important in solving the financial crisis than creating a law (an “insolvency regime law”) that empowers the government to handle complex financial institutions in receivership? Congress should pass such legislation — as requested by the administration — on a fast-track basis.”

It’s never a pleasant experience when a large firm goes bankrupt. But the real problem with Lehman Brothers was not that it went bankrupt; it was that it went bankrupt in a completely unforeseen and disorderly way. Likewise, the reason why it’s not a catastrophe when the FDIC takes over a bank isn’t just that the banks it takes over are smaller than Lehman Brothers; it’s that it has a very well-defined and orderly procedure that allows things that need to happen to go on happening while the bank is being taken over.

As long as we do not have such a procedure for dealing with insolvent banks like Citi or Bank of America, they will have a gun to our collective heads, and they will be able to go on extracting money from us. We might not like it, but the alternative will be worse.

For this reason, we obviously need to create a new alternative: a mechanism for taking over insolvent large banks that allows us to deal with them in an orderly fashion. Thomas Hoenig, President of the Kansas City Fed, proposed one such mechanism yesterday. I am not competent to say whether his version is best. But I do know that we need some such mechanism in place, and we need it immediately.

Relying on improvised deals and ad hoc solutions might have been necessary right after the crisis hit. But it is long past time to give ourselves the tools we need to do it right.

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