Peter Thal Larsen says: "Banks must embrace failure"

Mervyn King would like banks to contemplate their demise. Until now, most large financial institutions have carried on as if they are immortal, turning to taxpayers for life support when things went wrong. The Governor of the Bank of England wants the power to pull the plug. Bankers should find a way to help him do so.

Politicians and central bankers around the world are grappling with the problem of banks that are too big to fail. President Barack Obama's proposals for overhauling financial regulation call for a "special resolution regime" that would allow authorities to wind down large institutions that get into trouble. Philipp Hildebrand, vice-chairman of Switzerland's central bank, says there can be "no more taboos" when debating how to protect taxpayers from future problems at UBS or Credit Suisse.

Reform is long overdue. For years, big banks enjoyed an advantage because counterparties and creditors assumed -- rightly, in most cases -- that governments could not allow them to collapse. This encouraged increasingly reckless behaviour. The profits of success were distributed to shareholders and employees. The costs of failure were met by the public.

There are three ways to deal with this problem. One is to charge banks deemed to be systemically important for the guarantee they enjoy from taxpayers, possibly by making them hold more capital. A more extreme alternative is to simply stop them from becoming big. Hildebrand suggests capping market share, or limiting the size of their balance sheets as a proportion of gross domestic product. This would probably force many large banks to break themselves up.

Faced with these choices, a resolution regime looks like a better idea. Sure, funding costs would probably rise as creditors priced in the risk of failure. Trading houses would be forced to pay closer attention to the solidity of their counterparties. But these changes would strengthen the financial system. Meanwhile, with taxpayers' exposure limited, banks could resist attempts by regulators to micro-manage their businesses.

There are many questions about how a resolution regime would work in practice. It is unclear whether large books of derivatives contracts can be unpicked without destabilising the financial system. Applying a regime consistently across borders is another challenge. Who makes the final decision about whether to shut down a big bank? Would investors really believe such a threat was credible?

Bankers will instinctively oppose the introduction of these rules. But they shouldn't. The status quo is untenable and of all the alternative options for reform this looks the least bad one. Banks would be better off working with regulators to design a workable and credible regime. Making a will, as King describes it, is as necessary for banks as it is for the rest of us. Besides, nobody lives for ever.