Who should, who has to, pay to save the banking system? Shareholders? Taxpayers? Or bank creditors? After Lehman Brothers' bankruptcy, bank failure has been outlawed, thus preventing creditors and shareholders from absorbing bank losses, and leaving taxpayers to foot the bill.

    Let's go back to capitalism's fundamentals: shareholders and creditors bring their capital to companies and are paid dividends or interest in return. In exchange, they agree to absorb any losses. For banks, the regulator has been even more specific. After the shareholders, it has defined two classes of risk-taker, supposed to absorb any shocks in succession: long-term subordinated debt, so-called "junior debt," then long-term senior debt. Savers' deposits only - and for good reason - are guaranteed by the government. Legally, there has never been any question of the government guaranteeing junior and senior debt. Yet government's prohibition of bank failure de facto guarantees these bank debts. In this case, capitalism is perverted: creditors earn higher interest rates for taking a bank risk to which they are never exposed! How can creditors be made to pay without unleashing systemic risk? Two solutions are possible.

    First of all, in the case of imminent failure (cf. Dexia), it would be appropriate for the law to authorize an accelerated quasi-bankruptcy (an idea of Luigi Zingales from the University of Chicago). Before the reopening of the markets, a committee of wise men (Minister of Finance, Bank of France Governor ...), given the bank's losses, would proceed to a restructuring of the bank's liabilities: shareholders would be cleaned out; junior creditors would become shareholders or undergo significant losses; senior creditors would, in part, become junior creditors. The day after, the bank, with restructured liabilities, would be strong and well-capitalized, without excessive risk and would inspire market confidence. With this mechanism, there's no more systemic risk, no need for public money; the bank is healthy, risks officially recognized, and credit resumes.

    In the second case, the bank is not on the verge of bankruptcy, but its doubtful loans handicap it and prevent it from lending (cf. Japan after 1990). This Monday's Geithner plan in the United States and the Brown plan in the United Kingdom have in common an unsound idea: make the taxpayer pay (through either public guarantees or subsidized loans) a significant share for the purchase of toxic assets. Given the scope of the Geithner subsidy, it's to be expected that the markets would jump for joy. A far better solution was proposed by Bob Hall (Stanford), at www.voxeu.org: divide each problem bank into two, a mother bank and a subsidiary bank. The mother bank would keep existing shares and the substance of the junior and senior debt on the liability side of its balance sheet. On the asset side, the mother bank would have the worst half of the assets as well as shares in the subsidiary bank. This measure essentially aims to isolate the toxic assets and have their losses assumed by historic shareholders and lenders, without any public money. The subsidiary bank would have the mother bank's shares and guaranteed deposits on the liability side of its balance sheet and the healthy half of the assets on the asset side. The subsidiary bank would be healthy, well-capitalized and could easily lend into the economy.

    So why isn't that being done? First of all, many political leaders understand nothing about banking. The others are often under the influence of bank management (which is obvious with the Geithner plan and Wall Street, as well as with Gordon Brown and the City), which wishes to lose neither its shares nor its jobs. Bank creditors (insurers, pension funds ...) also create pressure for the taxpayers to pay instead of them. Finally, some predict an Armageddon should bank creditors have to pay. That's a failure to understand finance: if the restructuring of the bank's balance sheet has truly relieved it of its toxic assets, creditors will come back the next day to bring their capital to the healthy bank. And these same creditors will police the banks in the future in order not to be dispossessed [again]. The solution is simple: transform the law for bank failures so that creditors have to pay without putting a stop to the bank's operation.

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    Translation: Truthout French language editor Leslie Thatcher.

    Jacques Delpla is a member of the [French] Economic Analysis Council.