Treasury Secretary Timothy Geithner has decided that maybe banks should partially fund their own failures. Today Geithner announced that he plans to propose legislation that would create a risk fund backed by financial institutions. If large financial institutions were to fail, losses would be covered out of the fund. It’s an interesting idea, but I’m not sure how well it would work on a practical level.

1. Who says large financial institutions will fail?

After the failure of Lehman Brothers, retribution on Wall Street was quick and brutal. The government doesn’t want that sort of ruckus again. Indeed, the revisions of the bank stress test results is proof that the government is willing to do what it takes to prop up the big banks and keep them happy. Creating such a fund would take some of the pressure off the FDIC (and the taxpayers) for failures on a massive scale, but such a fund may not even be necessary — unless government policy changes and “zombie” banks are allowed to go under.

2. Who says financial institutions will pay into the fund?

One of the sad truths about the FDIC right now is that it could be in better shape. Why? Because there was a period of 10 years (1996 to 1006) in which banks did not pay their insurance premiums. They still remained covered, but they did not pay into the fund and the FDIC’s coffers are not as full as they should be as a result. The FDIC isn’t in imminent danger, but it could be more financially secure. What if the big financial institutions don’t pay into the fund? I doubt Congress would be any more particular about forcing compliance on the big banks than they were in the case of the FDIC.

The bottom line: It sounds nice that Geithner wants to create a fund — backed by the insitutions it would protect — to help defray the costs of large bank failures. However, it won’t be particularly practical if there is no danger of bank failure and/or if the institutions don’t pay into the fund. Instead, a fund designed to loan money to banks that need capital might be in order. Kind of like a TARP, but without using taxpayer money.

What do you think of the idea of a risk fund?