The federal government is getting criticized because it has not been able to get the frozen U.S. banking system to start lending money again. Many Americans resent injecting taxpayer dollars into beleaguered banks to get them lending again. After all, commercial bankers were among the villains that caused the global financial crisis. Why should they get bailed out with taxpayer money?

There is a simple answer: No economy can function without having banks and other sources of capital available to provide credit to both businesses and households on a regular basis. Without well-functioning banks the economy collapses, leading to massive unemployment and declining incomes.

The main reason most banks are not lending is that many have billions of dollars of toxic assets on their books that are not worth what the banks paid for them. The banks can neither sell those assets to use the capital to lend, nor use those assets as reserves in making new loans.

Search for solutions

Washington keeps coming up with myriad ways in a desperate attempt to end the crisis, but nothing has worked. The Federal Reserve opted to keep home interest rates low so that Americans would be encouraged to buy homes, but that did not remove any toxic assets.

Another idea was to use billions of taxpayer dollars to buy ownership positions in banks through preferred stock, thereby supplying the banks with some quality capital. But that approach did not remove many toxic assets off banks' books and failed to restart lending.

Yet another approach was to merge failing banks with successful ones. But that requires paying the successful ones to take the failed banks' assets over; and it's expensive. Merrill Lynch was taken over by Bank of America, but it cost the federal government billions.

Why not just let the failed banks declare bankruptcy, wipe out their equity and fire their managers? As popular as that solution might be, it's a bad idea. The 10 largest banks in the U.S. possess almost two-thirds of all the federally insured assets in U.S. banks and savings and loans. The four biggest banks posses over half of those assets.

The stocks of the big banks are owned primarily by institutional investors in which millions of Americans have invested their savings. If all those big banks went bankrupt, the stock still owned by American households holding out hope for a recovery of value would be totally wiped out. It would be a psychological disaster for the Americans to lose all those assets.

Good bank, bad bank

The final way to remove the toxic assets is for the federal government to buy them. One solution is to require that the banks evaluate all their assets by dividing them into toxic and sound groups. The government would be able to verify the bank assessments, and then buy the toxic assets at a big discount.

The government would guarantee to take all the losses, if upon resale the assets proved to be worth less than what they paid for them. Conversely, if upon resale the assets proved more valuable, the government would share half the profits with the banks concerned.

The toxic assets would be held in a “bad bank” within each financial institution, managed by the bank itself. In order to stimulate more lending, the Federal Reserve for a limited time of one to three years would reduce the existing lending reserve requirements from roughly 10% to 5%.

That would double the lending capacity of the banks from the base of their good assets resulting from the federal government's purchase of their toxic assets, plus whatever good assets they already had, plus any new capital they could raise. By keeping the toxic assets within many banks rather than in one national “bad bank,” the government would save administrative costs.

If all these changes were to occur, outsiders could invest in buying stock in these banks without fear of having to cope with toxic assets. If the newly approved stimulus package generates more economic activity, then opportunities will arise for banks to make money by lending to firms and households.

Tony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.