I quite liked Neil Irwin’s story today, in the aftermath of earnings season at the big banks, an an object lesson into how those firms still carry a multitude of legacy troubles from the crisis years:

All of these banks are still grappling with the costs of the bad lending during the boom years before the crisis. They also are trying to determine how big they ought to be in a world where they cannot rely on such a large ratio of borrowed money (thanks to Basel III capital requirements), run some lucrative side businesses (thanks to the Volcker Rule that tries to stop proprietary trading) or have regulators all up in their noses over their ability to manage risk in their sprawling financial empires (thanks to the Dodd-Frank act) [...]

Consider the ongoing legal settlements. The banks have long since written down the direct losses from the bad mortgages on their books. What few would have foreseen is the long tail that has stretched from those lawsuits over bad lending.

In other words, the banks have long since written down their losses on “collateralized debt obligations,” securities created from various pieces of other mortgage securities like a Frankenstein’s monster. They’ve written down their losses on “CDO-squared,” the even more complicated variation in which CDOs were formed from pieces of other CDOs. But they are just now reckoning with CDO-cubed: the legal exposure they face from selling all those CDOs and CDOs-squared that turned out to be worthless.

The banks are reserved for most of these settlements, which at the law enforcement and regulatory level have been piddling, and at the investor level have not yet borne the full impact. But because one sympathetic judge could blow a hole in this theory that banks can handle the fallout, that uncertainty remains. It’s the same on prop trading and capital requirements, though I don’t quite see these as precarious as Irwin does.

The larger point here is this: zombie banks stunt growth in economies. All the reserves for legal trouble represent money not being lent into the economy. Wall Street law firms get full employment but small businesses do not. The working theory of the financial crisis is that we had to “save the banks,” but nobody asks whether these banks were worth saving. We make a mistake identifying particular banks as “the financial system.” Banks can come and go. The system ought to survive, but there are ways to do that without propping up the status quo with trillions of emergency funding.

As Steve Randy Waldman writes, we actually need MORE failures in the financial space. He describes them as controlled burns.

So we need a regime where banks of every stripe actually fail, even during periods when the economy is humming. If we want financial stability, we have to force frequent failures. An oft-cited analogy is the practice of setting occasional forest fires rather than trying to suppress burns. Over the short term, suppressing fires seems attractive. But this “stability” allows tinder to build on the forest floor at the same time as it engenders a fire-intolerant mix wildlife, creating a situation where the slightest spark would be catastrophic. Stability breeds instability [...] We must deliberately set financial forest fires to prevent accumulations of leverage and interconnectedness that, if unchecked, will eventually provoke either catastrophic crisis or socially costly transfers to creditors and financial insiders.

That’s precisely the right analogy to make, especially given the kindling with all the legal exposure among the mega-banks. You could design a system where these forced failures only disrupt creditors and shareholders rather than depositors or the public at large, and for them, it’s really a natural part of risk-taking to have the possibility of failure in the mix.

Put it this way: would we rather have bank creditors, shareholders and management inconvenienced, or the entire country, when the zombie banks finally collapse under all the accumulated exposure?