Create A New Banking System Now

The challenge we face, and the challenge the administration is grappling with, is what to do with insolvent financial institutions.  If you let them fail it will send the market into a panic.  Credit will seize up as it did when Lehman went under.  Without credit, the engines of the economy - at least the engines of large business - grind to a halt.  The fear mongers tell us that jobs will be lost and all commerce will stop.  Whether that will be the result or not is unknown, but there is no question that the catastrophic failure of banks without a replacement financial system in place would have far reaching consequences.  

Here is an idea floating around.  Instead of spending money trying to keep insolvent banks afloat while all their bad loans come home to roost, spend the money now to create a new banking system that will be in place when the insolvent banks inevitably fail.  David Warsh in his blog , Economic Principles, suggests using government money to set up half a dozen start-up wholesale banks, and once they get to borrowing and lending freely, sell them off to the public.  Once these banks take root, we can dismantle the existing Wall Street system that cannot survive.  

Common sense tells us that this can be done rather quickly - especially with full government backing.  Imagine newly chartered banks with fresh capital and no legacy obligations.  Depositor would be attracted to them for they would at the same time have a lower risk than Bank of America, Citgroup, JPMorgan or any of the other large mega banks burdened by bad loans and hard to value assets.  Whether money would be lent out is a very different question.  The fact remains that in times of uncertainty there can be little faith that sums lent will be repaid except only to the most credit worthy of all the borrowers.  Prudence should remain the backbone of lending, and the reason we are even discussing the banking crisis is because these banks made impudent loans and/or purchased assets backed by these imprudent loans.  Nevertheless, there will come a time when the risk reward ratio will make sense, and these newly created institutions would have the ability to lend.  Further, the swift privatization of these new banks will assure that taxpayer funds get repaid to the treasury.

Once the system is in place, we can cut the life support to the insolvent banks and let the shareholders and bondholders get what they deserve.