An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System

Abstract

The magnitude of the current financial crisis reflects the failure of an economic and regulatory philosophy that had proved increasingly influential in policy circles over the past three decades. This paper suggests (1) that contrary to the prevailing wisdom, New Deal policies (including federal deposit insurance and bank supervision) worked to stabilize the financial system; (2) that the financial catastrophe of 2007-2009 was not an accident, but rather a mistake, driven by a deregulatory mindset that took 50 years of post-New Deal financial stability for granted; and (3) that the dramatic federal response to the current financial crisis has created a new reality, in which virtually all systemically significant financial institutions now enjoy an implicit guarantee from the federal government that will continue to exist (and continue to generate moral hazard) long after the immediate crisis passes. Based on this analysis, one major step that is necessary now to help ensure financial stability in the future is to identify and regulate systemically significant institutions on an ongoing basis, rather than simply in the heat of a crisis. To guard against moral hazard (in the face of large implicit guarantees) and to ensure the safety of the broader financial system, these institutions must face significant prudential regulation, they should be required to pay premiums for the federal insurance they already enjoy, and they should be subject to an FDIC-style receivership process in the event of failure.