The G-20’s decisionin November 2008 not to let any systemically relevant bank perish may haveseemed wise at the time, given the threat of a global financial meltdown. Butthat decision, and bad policies by central banks and governments since then,has given over-indebted major banks the power to blackmailtheir rescuers – a power that they have usedto create a financial system in which they are effectively exempt fromliability.

Big banks’ ability to extort such anarrangement stems from an implicit threat: the financial sector – and with itthe economy’s payment system – would collapse if a systemically important bankwere ever pushed into insolvency. But it istime to call the bankers’ bluff: maintaining the payment system can and shouldbe separated from the problem of bank insolvency.

Above all, the G-20’sdecision to prop up systemically relevantbanks must be revisited. And governmentsmust respond to the banks’ threats by declaring their willingness to letinsolvent banks be judged accordingly. A market economy must rest on theeconomic principle of profit and loss. An economy with neither bankruptcies nora rule of law that applies equally to all is no market economy. The law that isvalid for all other companies should apply to banks as well.

Moreover, governments should guarantee insolvent banks’ loans tonon-financial companies, as well as private customers’ current, fixed-term, andsavings deposits, by reforming insolvency laws. Certainly, governments shouldnot guarantee interbank liabilities that do not affect customer deposits. Aninsolvency administrator would manage the bank and ensure that all payments forwhich a state guarantee is given are carried out properly, with refinancing ofthese payments continuing to take place via the central bank.

After taking these steps, the payments system would be safe. In case ofinsolvency, a bank’s computers would not be turned off, its employees would notinstantly be dismissed, and payment transactions would not collapse. Nor woulda run on savings deposits occur, given the official guarantees that they remainunaffected by a bank’s insolvency. After all, even a simple banknote is money only because the government saysso, and thus is no different from savings deposits, which means that no saverhas an advantage from holding cash. So there would be no need for bank runs.

Of course, the deliberate restriction of the effects of bankruptcy toaccounts other than private current, savings, and fixed-term deposits meansthat the insolvency of bank A could lead to the insolvency of bank B. For bankB, too, the same liquidation scenario would apply: savings deposits would besafe, payments could be made from its customers’ current deposits, and loansthat it granted to non-financial companies would not be revoked.

Obviously, the domino effect need not stop there: the insolvency of banksA and B could get a bank C – and additional banks – into trouble. Indeed, theentire over-indebted fractional reserve-banking subsystem might have to be liquidated. But the payment system would survive.

This might trigger a positive domino effect as well, as other states – ongrounds of international financial integration – adopt similar procedures forcontrolled liquidation of their own insolvent banks. Zombieassets would be destroyed. A large part of the money and credit that wascreated out of nothing from former interbank transactions, now excluded fromofficial guarantees, would return to nothing. Afterwards, the liquidated,formerly over-indebted banks could be sold.

We have it in our power to eliminate the financial system’s rapidlygrowing debt and to create a new monetary order that corresponds tofree-enterprise principles and the rule of law, without risking a breakdown ofthe entire payment system. All that is required to revive effective bankregulation – in Europe and elsewhere – is thewill to resist blackmail by the banks themselves.