By: Matthew Arndt, CFA, CPA, CFP | February 1, 2010 | The Politicians, The Regulators

It’s conceptually simple: take away any government protection for stockholders, management and creditors of large financial institutions to help shrink their appetite for risk-taking. For instance, in the case of the Bear Stearns debacle stockholders should have been wiped out; management should have been fired; and the bondholders should have suffered significant losses. Instead, stockholders received a renegotiated price of $10 per share; incompetent management was retained; and as it stands, the debt-holders of Bear Stearns stand to receive all interest payments and 100 percent of principal. This latter approach does not instill market discipline or uphold capitalistic ideals.

By not having consequences for taking risk, our current approach to protecting banks facing insolvency will only create moral hazard which implies that financial institutions deemed “too big to fail” can continue to count on public support at critical times. This perceived public “safety net” will only encourage excessive speculation at large commercial banks and will undermine the stability of our financial system unless sensible reform is implemented. There needs to be a mechanism by which any failing institution allowed to receive public aid would be subjected to an orderly dismantling where taxpayers would not be exposed to excessive losses in the event there is a bankruptcy. Creating considerable negative consequences for those involved in risk-taking at banks will go a long way to stabilizing our financial system.