As published on WSJ.com on May 6, 2009:

By R. GLENN HUBBARD , HAL SCOTT and LUIGI ZINGALES

Insolvent institutions should be taken over by the FDIC.

The results of bank stress tests — expected tomorrow — will no doubt prompt calls for further government guarantees and capital injections. But continuing to prop up the banks with government cash is a mistake. There is a better approach.

A well-capitalized banking sector is a necessary ingredient for effective intermediation and economic recovery. But today’s system is not well-capitalized. How can we move in the right direction?

In a market economy, the government can create the right incentives by using a combination of carrots and sticks. Thus far, the government has only used carrots with the banks. One major carrot is the Troubled Asset Relief Program (TARP). The initial infusions were very generous — the Treasury got back securities worth $78 billion less than the $254 billion it invested — as the Congressional Oversight Panel pointed out recently. In addition, the FDIC’s guarantee of short-term debt was worth $100 billion just for the original nine TARP-participating banks. And the mortgage-related asset guarantees offered to Citibank and Bank of America were worth tens of billions of dollars more.

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