The case for simple rules and limiting the safety net.

• Author: Hoenig, Thomas M.

For the last 100 years, government officials and bank CEOs have insisted that new policies, rules, and laws--combined with greater market discipline, resolution schemes, and enhanced supervision--would ensure that future financial crises, should they occur, would be more effectively handled. In the United States, the creation of the Federal Reserve System and Federal Deposit Insurance Corporation are examples where such assurances were given to the public. More recently, the FDIC Improvement Act of 1991 and other legislation were intended to end public bailouts of failing banks and, in particular, prevent the moral hazard problem inherent in "too big to fail." Such assurances seem even more significant following a U.S. Treasury (1991) study that found that "too big to fail" resolution policies used for six of the largest banks cost taxpayers more than $5 billion (in current dollars). If only the cost of the six largest bailouts in this recent crisis were just $5 billion. Unfortunately, it was many times greater.

Incentives matter and the incentives toward risk taking among the largest financial firms remain basically unchanged from pre-crisis times. Despite the enormous regulatory burdens placed on financial firms, post Dodd-Frank, these firms continue to be driven toward leverage. With time, we can be confident that our financial system will once again become highly leveraged and the economic system will become more fragile as a result.

To change outcomes, you must change incentives. With the safety net, you alter the market's incentives, create moral hazard, and drive toward leverage that creates its oven set of adverse consequences. There are three steps that I suggest be taken to control these negative effects: (1) limit the safety net's protection, (2) simplify and strengthen capital adequacy standards, and (3) improve bank supervision. Each of these will be discussed in turn.

Limiting the Safety Net's Protection

It is important to recall that following the Great Depression, when the safety net was greatly expanded with FDIC insurance, which was in addition to the Federal Reserve's discount window, Congress and other policymakers understood that something needed to be done to control the moral hazard problem inherent in the safety net. The tradeoff was to limit FDIC insurance to commercial banks because of their importance to the payments system and the intermediation process from saver to borrower. Higher-risk investment banking and...