What Caused the Current Financial Mess and What Can We Do about It?

Abstract

In our view, the financial crisis was largely due to wrong incentives affecting the behavior of financial institutions and investors that was set in motion by our government’s reluctance to let large financial institutions fail – i.e., the Too Big to Fail (hereafter, TBTF) policy. Also importantly, bank regulation became essentially ineffective due to the rise of “quasi-banks,” that is, large financial intermediaries that perform banking functions but are not chartered or regulated as banks. In order to prevent the recurrence of such a mess, we argue, the government must identify the quasi-banks and regulate them as banks. It must also credibly convince investors that the TBTF policy is a thing of the past. For that to happen, we call for two major changes in the current structure of financial supervision in the US.