Susan Woodward and Bob Hall illustrate nicely how a partitioning of an existing bank into a good bank and a bad bank could work. The key is that the good bank is a wholly owned subsidiary of the bad bank. The good bank holds the insured deposits of the current bank, along with all of the assets of sufficiently high quality. The bad bank holds the liabilities other than the deposits and owns the remaining assets and all of the equity in the good bank. Here is how they describe the rationale for making the partition:
Now one might wonder, given that the intrinsic claims of neither the bond holders nor the equity holders has changed, why bother? Pundits talk about the toxic assets in the banking system as if somehow they were infectious, and the good assets would become infected by the bad assets. One envisions the mold on one piece of cheese taking up residence on an adjacent piece in the frig. Or that somehow if the bad, hard-to-value, assets were moved somewhere else, both sets of assets would be easier to value and the banking system somehow more sound. We don't think the bad assets are infectious. Nor do we think this re-arrangement increases or changes values or facilitates the valuations of the assets behind the banking system. What the change does do is make ever-so-clear what the priorities are in an insolvency. Note that in this re-arrangement, the debt claims, including the short-term commercial paper, are direct liabilities of the bad bank. If the bad bank cannot re-fund its commercial paper one morning, the bad bank must be re-organized. Some of its claims must be turned into equity. This is the standard sort of Chapter 11 re-organization.
Exactly -- no more bailout in lieu of bankruptcy, and no run on the solvent part of the bank. Read the whole thing.