Washington Mutual (NYSE:WM) recently became the biggest bank failure in American history. With over $300 billion in assets at the time of its collapse, it easily dwarfed any other doomed bank ever to cross paths with the FDIC. It's quite a tragedy for its employees, investors, and perhaps even depositors who handed the bank over $100,000.

Yet amid the chaos, there is a bright lining to its dark cloud: Not a single dime of taxpayer money will be used to protect FDIC insured deposits at the bank. Instead, JPMorgan Chase (NYSE:JPM) bought Washington Mutual's banking business and will make sure those depositors will be covered up to FDIC limits. All this without a bailout plan in place.

Where's the "systemic crisis"?
The speed with which JPMorgan was able to muster its deal after Washington Mutual's collapse does raise questions about the fairness of the transaction. That it happened at all, however, is a testament to the resiliency of the vulture capital market, even amid the current crisis. It worked out, of course, because JPMorgan saw the opportunity to swoop in and make a quick buck on the heels of Washington Mutual's collapse.

Think about that for a second. We just had the biggest American bank failure ever. The headlines are full of paranoid screaming about how financing has completely dried up. Yet somehow a rescue deal was reached in a heartbeat that:

  • Protected the same people that the current government safety net does,
  • Involved no taxpayer dollars, and
  • Is anticipated to be immediately accretive to the acquiring company's earnings.

Could there have been a better resolution to an otherwise sticky problem? Perhaps, but at least this one didn't put taxpayers on the hook.

Bring on the successful failures!
In any healthy capital market, there's a risk/reward trade off. If you are putting your money at risk, you're doing so for the expectation of a reward. In general, the more risk you take, the more reward you can expect to receive if your risks turn out to be successful. For that market mechanism to function properly, the folks who take on risks that don't pan out must feel the financial pain of their failure.

In the capital market, having the participants feel the financial pain of their own failures serves some absolutely critical functions:

  • It entices people to make intelligent choices with their cash. If you're likely to lose your money if your investment doesn't succeed, you'll probably only be willing to invest in those ideas that have a legitimate shot of working.
  • It limits the collateral damage of a failed investment largely to those who were involved in the investment. Compare that to the tragedy of the commons that occurs with bailouts when one person gets the reward for a risk but all of us share the costs of its failure.
  • It gives the successful companies more "white space" to expand. After all, not only will their risks be rewarded, but their unsuccessful competitors will not be able to stick around long to cause more grief in the market.

Some banks should win
The spate of bank failures this year has been largely concentrated among companies that took on excessive risks compared with their true capital base. The two major classes of failures have been investment banks taking on extraordinary leverage to juice their returns and commercial banks betting big on subprime borrowers. Nearly every other bank has either done fine or had access to enough resources to cover their failures.

US Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC), and BB&T (NYSE:BBT) are in much stronger positions now for having stayed largely out of subprime lending. They may have missed out of the phantom gains when subprime appeared to be working, but by recognizing the real risks and refusing to invest in it, they should be rewarded for their decisions.

Likewise, along with JPMorgan, Bank of America (NYSE:BAC) and Barclays (NYSE:BCS) have picked up the remains of many of the failures wrought by the subprime meltdown. Their astute capital management and prudent risk taking now allow them to reap the long run rewards the marketplace offers to those who don't bite off more than they can chew.

What future do you want?
In a functioning system that rewards success and punishes failure, in the long run, you get more banks like JPMorgan, Bank of America, US Bancorp, Wells Fargo, Barclays and BB&T. In a system where failures are rewarded with bailouts, you get more banks like Washington Mutual, Bear Stearns, IndyMac, and Lehman Brothers. For the good of your own pocketbook, the banking system, and the economy as a whole, let the market weed out its failures and reward its successes.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.