When I was chairman of the FDIC and the Resolution Trust Corporation (RTC), the country was in a financial mess: Hundreds of insolvent government-insured institutions were dragging down the economy, much like our economy today—only not as bad.

Then, as now, the economy had two great needs. One was to restore confidence and lending to qualified borrowers, and the other was to recognize reality by weeding out institutions that are insolvent. The central challenge has always been to achieve these objectives in the least costly way with the least possible disruption to the economy.

The stark difference in government response now compared to then is that we used a closed-bank strategy. Today government policy amounts to open-bank assistance. In the closed-bank system, if a bank couldn't operate without help, it was declared insolvent and closed for repair and resale. Today, troubled banks' requests for help result in the sales of preferred stock to the government.

Hindsight has shown the wisdom of the strategy developed to deal with the so-called S&L crisis. The essence of that strategy was special legislation that empowered the FDIC and the RTC to create bridge banks.

Bridge banks were new institutions that took over failing banks—those that were insolvent on a capital or liquidity basis. The shareholders of failing banks lost their ownership and unsecured debt was reduced to market value at takeover.

The process included three key elements. First, the new bridge bank, which took over the insolvent bank, continued its operation so that the disruption to the economy was minimal. Second, new stock was issued to the FDIC-RTC. Third, bank managers were usually replaced with a fresh group of executives who had no past mistakes to justify.

This approach was not merely efficient, it also provided seamless stability for depositors and borrowers. Moreover, it was much more equitable than the current open-bank assistance policy in that it did not reward investors in or unsecured debt holders of failed institutions.

After takeover, the FDIC (sole shareholder) removed all the "bad loans" and other problems from banks, leaving a clean bank. The new "clean" bank was then sold back into the private sector. A new bank with no bad debt exposure will normally be profitable from day one (ask Hugh McCall of Bank of America, who was a major purchaser of these bridge banks).

We called these entities bridge banks because they were a bridge between the takeover from the private sector to the subsequent sale back to the private sector. (They could be called short-term nationalizations, but we never used those terms.)

There are several big advantages to this bridging approach:

• The bad assets can be sold to the private sector over a period of time as the real values are established in the marketplace using the many methods developed by the FDIC-RTC.


• The system has been tried and succeeded 20 years ago and thus there are capable people from that era to guide us today.


• The moral hazard of government's too-big-to-fail policy is greatly reduced since the shareholders of the insolvent institution lose their entire interest and the management is replaced. The government will no longer be used like an insurer who abides costly mistakes. At the same time, creditors are protected in order to maintain normal operations throughout the process.


• Finally, the cost to the taxpayer is generally reduced since the FDIC-RTC can, over time, find the best market for the impaired assets, ultimately obtaining the real value for them rather than selling at a "panic price."