Jamie Dimon’s congressional testimony on trading losses has again stirred debate on the notion of “too-big-to-fail” banks.

JPMorgan Chase & Co.’s losses were buffered by a strong balance sheet and sufficient capital levels to avoid putting the bank at risk. Nevertheless, opponents of the Dodd-Frank financial reform’s resolution process have used this to resurrect their belief that the law has not ended “too big to fail,” but instead codified it into law. As former bank regulators who both sat on the Federal Deposit Insurance Corp. board, we disagree.

The FDIC recently proposed a way under Dodd-Frank of reorganizing a large financial institution that would avoid runs by short-term depositors and creditors and prevent messy defaults on swaps and other derivatives. More important, the FDIC’s proposal would also avoid taxpayer losses, which Dodd-Frank flatly prohibits. Instead, losses would be borne by shareholders and long-term creditors of the failed holding company. Long-term creditors would swap their debt for equity to recapitalize the company.

The process would be functionally identical to a Chapter 11 reorganization under the Bankruptcy Code, with two critical exceptions: It could be done much faster, and, if necessary, the Treasury Department could provide temporary loans (backed by collateral) to the reorganized company until market funding returns.

Living Wills

The FDIC proposal is certainly not perfect, and there are many practical issues that need to be worked through. That is exactly what the FDIC is doing, in consultation with regulators from other countries. It is also what financial institutions are doing through the new living-will process, in which they must present plans for reorganizing or liquidating themselves in an orderly way in the event of failure.

We believe that, unlike the U.S. Bankruptcy Code, the FDIC’s proposal is a credible bankruptcy mechanism for resolving large institutions without causing financial panic. Putting a large banking organization through the normal bankruptcy process, especially during periods of financial stress, can lead to disaster. Banks are like melting ice cubes; the normal bankruptcy process is slow and deliberate. The combination is lethal.

A bank’s franchise value can rapidly melt away before the bankruptcy process is over, leaving depositors and other creditors with far less than the face amount of their claims. The fear of such an outcome can cause runs by short-term depositors and creditors, which can spread to healthier institutions. Such uncontrolled panic can destabilize the system and result in enormous long-term damage to the wider economy.

That is why U.S. banks have always been excluded from the Bankruptcy Code, even before deposit insurance was developed. Instead, they have been reorganized or liquidated under special resolution laws administered by their regulators or the FDIC.

One of the gaps exposed during the 2008 financial crisis was the lack of a special resolution law for other financial institutions, such as holding companies of banks, broker-dealers or insurance companies. When one of these financial institutions failed, the regulators had to choose between allowing the institution to be put through the normal bankruptcy process and risking a collapse of the financial system, or bailing it out with taxpayer money. It is not surprising that, except in the case of Lehman Brothers Holdings Inc., they chose bailout as the lesser of two evils.

Orderly Liquidation

The so-called orderly liquidation authority in Dodd-Frank closed this gap by creating a special bankruptcy law for non-bank financial institutions modeled on the bank resolution law. The FDIC’s proposal would use the new law to produce a streamlined version of a managed reorganization under Chapter 11 of the Bankruptcy Code. This would be achieved by placing the parent holding company into receivership and simultaneously transferring all of its assets, including subsidiaries, to a bridge holding company.

Importantly, the holding company would absorb all losses incurred at its subsidiary bank, broker-dealer or other units by injecting capital to offset the losses. That is, the holding company’s shareholders and long-term creditors would bear these losses, not the depositors or creditors of the subsidiaries. Once this process is understood by the market, depositors and other short-term creditors of the newly healthy subsidiaries would have no incentive to run. This approach would also help to avoid the foreign impediments to resolving a bank with global operations.

The FDIC’s proposed solution is a credible alternative to the unacceptable choice between a panic-accelerating liquidation or reorganization under the Bankruptcy Code and a taxpayer-funded bailout. To be sure, certain details remain to be worked out. But it appears to have all of the essential characteristics to solve the too-big-to-fail problem. The U.S. Bankruptcy Code does not.

(John C. Dugan is a partner at Covington & Burling LLP and a former U.S. comptroller of the currency. T. Timothy Ryan Jr. is president and chief executive officer of the Securities Industry and Financial Markets Association and former director of the Office of Thrift Supervision. The opinions expressed are their own.)

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To contact the writers of this article: John C. Dugan at jdugan@cov.com and T. Timothy Ryan Jr. at tim.ryan@sifma.org.

To contact the editor responsible for this article: Paula Dwyer at pdwyer11@bloomberg.net.