Tuesday, 22 December 2009

"Too big to fail"

Oliver Hart and Luigi Zingales write in How the Tricks That Crashed Wall Street Can Save the World
What really caused the 2008 meltdown -- and is certain to create and burst bubbles in the future -- are the financial industry's distorted incentives. For the past three decades, the most fail-safe way to make money on Wall Street has been to take on risk, borrow, and bet; the crisis did not change that. Either you are lucky and you make a bundle, or you are unlucky and you walk away. In other situations, creditors dampen this opportunistic behavior by imposing covenants and monitoring borrowers. But why bother if the government will bail out ruined gamblers? Then, loans are valuable for borrowers and lenders alike, albeit disastrous from the taxpayer's point of view.
The problem of moral hazard resulting from "too big to fail".

Hart and Zingales continue
The implicit policy of bailing out large financial institutions -- those behemoths widely thought of as "too big to fail" -- will become explicit if the administration's regulatory reforms are approved. They do not stop the encouragement of bald risk-taking by removing the guarantee that the government will never let big, systemically important banks crater.
That is, the US government's plan to reform its financial sector does not address the fundamental cause of the crisis, nor will they help the world avoid more financial disasters down the road. The problem of moral hazard resulting from the government's regulatory framework is a ticking time bomb.

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