Higher capital requirements and annual stress tests hopefully make another financial meltdown less likely, and living wills might help with the orderly dissolution of individual banks when the next crisis hits, but no one really believes the government will let the financial system collapse if we have another 2007-style failure. Attempts to move beyond too big to fail have a credibility problem.

Confronting Too Big To Fail With Reorganization Bonds

But a proposal from Steven Gjerstad, a presidential fellow at Chapman University, and Vernon Smith, a Chapman University economics professor and 2002 Nobel laureate, could solve the issue by putting shareholders in a first loss position by creating a new asset class: reorganization bonds.

“Instead of living wills or government bailouts, we propose that banks issue a class of bonds to privately secure the financial system against a cascade of failures,” they write in The Wall Street Journal. “In bankruptcy, the existing board of directors would be dismissed, the equity of the firm would be eliminated and the Class R bonds would immediately be converted to equity.”

Reorganization bonds put shareholders first in line for losses

This might seem severe at first glance, but it eliminates the biggest problems with government bailouts. It gets rid of moral hazard because the people who benefited most from banks’ risky decisions in the past, the shareholders, are the first to absorb losses. Shareholders who don’t want to lose their investments should make sure that a bank’s balance sheet is in good condition or take their money elsewhere. The conversion from reorganization bonds to common equity would mean taking a loss in the short-term, but it would also put the new owners in charge of a healthier bank with fewer liabilities (reduced by the size of previously outstanding reorganization bonds, specifically) that could restructure the rest of its debt and start to recover.

Reorganization bonds insulates taxpayers from another round of huge bailouts

Reorganization bonds would also protect taxpayers from having to prop up financial institutions. Gjerstad and Smith estimate that if American financial institutions had been forced to issue R bonds for 8% of balance sheet liabilities, all but American International Group Inc (NYSE:AIG) would have pulled through the crisis on their own. With only one failing institution to deal with, the government would get to choose between a much smaller bailout or putting the institution into receivership – without the threat of a collapsing economy forcing snap judgments.

It doesn’t hurt that Gjerstad and Smith’s plan would get rid of the board of directors and shake-up senior management, so the whole issue of giving bonuses to people who almost wrecked the economy would be blunted. There are other details that would need to be worked out to be sure, like what the tax implications of conversion from R bonds to equity might be, but giving shareholders a good reason to avoid extreme risks is a great starting point.