Simon Johnson, the crowned prince of Wall St. bashing who was recently named the "public intellectual of the year," is especially concerned with the federal government's implicit promise to back the financial system when it crashes. He argues that this leads to a "doom loop" in which banks are encouraged to bet big, especially on sectors like housing that they know are partially backed by the government. Ben Bernanke, writing to Sen. David Vitter (R., La.), addressed the problem this way:
The "doom loop" that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise.
A new regulatory structure should address this problem. In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm's shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.
Maybe Dan sees this differently. But I don't understand how a stronger financial regulatory structure is going to fundamentally change the pernicious incentives of banks to overinvest in risky markets when they know the government is likely to set a floor for their losses. This strikes me as especially true when the investment are backed by payments in sectors like housing where the government has a big stake and a big interest in ensuring the viability of the market. I'm sure that financial regulation hallmarks like higher capital requirements and even an insurance fund banks are required to contribute to could make our biggest banks a bit smaller, and therefore make their failure less of a threat to the health of the economy. But a solution to the deeper problem is admittedly elusive.
I wonder whether the more honest answer is: "We can't really fix the doom loop, because as much as the implicit guarantee of a bailout for large institutions is arguably a cause of financial busts, it's also the one way we know how to keep our financial crashes from becoming apocalyptic economic events. Realistically, the solution isn't to break the cycle with some earth-shattering decree that there shall be no more bailouts. The solution is to make the banks smaller, more responsible for their own long-term health, and better regulated."