04 May 2009Working Paper Summaries

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

by David A. Moss

The present financial crisis should remind us that private financial institutions and markets cannot always be counted upon to manage risk optimally on their own. Almost everyone now recognizes that the government has a critical role to play—as the lender, insurer, and spender of last resort—in times of crisis. But effective public risk management is also needed in normal times to protect consumers and investors and to help prevent financial crises from starting in the first place. According to HBS professor David Moss, the biggest threat to our financial system today is posed not by commercial banks (as in 1933), but rather by systemically significant institutions (outside of commercial banking) that have the potential to trigger financial avalanches. The threat posed by these financial institutions is only compounded by the unprecedented federal guarantees introduced in response to the current crisis and the pervasive moral hazard they spawn. Under the system that Moss proposes, no financial institution would be too big to fail. Key concepts include:

Ensure financial stability in the future by identifying and regulating systemically significant institutions on an ongoing basis, before crisis strikes.
The biggest risk management problem we face today in the financial sector is not commercial banks, but rather systemically significant institutions that pose a threat to the broader financial system (because of their size and interconnectedness) and, as a result, carry implicit federal guarantees.
The fifty years of relative financial calm that followed the Glass-Steagall Act of 1933, the Securities Exchange Act of 1934, and the Banking Act of 1935 strongly suggest that sound public risk management can make a positive difference.
To the extent that systematically significant financial institutions will receive federal support in the event of a general financial crisis, such support should be formalized (and paid for) in advance. Although all government guarantees can generate moral hazard, implicit guarantees are often the worst kind.

Author 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. 14 pages.