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How to Bail out Good Banks and Let Bad Banks Fail

LOS ANGELES – How should large-scale systemic failures of a country’s financial system be addressed? Nobody wants to bail out banks that make bad decisions. But to save a financial system from collapse requires preventing all banks from failing at the same time. We need a way to bail out good banks but allow bad banks to fail. But how can we distinguish good banks from bad?

When markets panic, as they did in 1929 and again in 2008, supporting the financial system is essential. The alternative would be a 1930’s-style depression. But that does not mean that we should bail out individual banks.

Recent economic history is replete with examples of financial crises: the United States in the late 1980’s; Sweden, Finland, and Norway in 1992; Japan in 1998; and much of the world economy in 2008. The ways these crises were handled offer important lessons.

In 1992, Sweden’s central bank, the Riksbank, allowed private bank equity holders to be wiped out, but it rescued depositors and creditors by buying up risky assets of failing institutions. Sweden recovered.