Moral Hazard During the Savings and Loan Crisis and the Financial Crisis of 2008-09: Implications for Reform and the Regulation of Systemic Risk Through Disincentive Structures to Manage Firm Size and Interconnectedness

Abstract

In the aftermath of the most recent financial crisis, policymakers and regulators have faced the formidable challenge of designing regulatory reforms that adequately address the problems of moral hazard and “too big to fail” in banking. While these concepts have remained persistent stumbling blocks in bank regulatory policy, the modern landscape of the financial services industry has introduced new challenges in the areas of systemic risk and the concentrations of financial power held by a few dominant firms.

This Note compares and contrasts the causes of and responses to the subprime mortgage crisis with those of the Savings and Loan Crisis of the 1980s. It concludes that the provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act intended to address “too big to fail” actually represent the same type of traditional responses to banking crises as seen before. By subjecting systemically significant firms to more stringent operating requirements and closer monitoring, current reforms merely treat complex financial conglomerates as traditional depository institutions whose incentives can be adequately managed through prudential regulation customarily used to counteract the moral hazard of deposit insurance. To deal with the moral hazard of systemic risk, however, reform efforts should place greater emphasis on anticipatory regulation in a framework of stronger disincentives to discourage growth towards “too big to fail” status.

This Note also supports the recommendation of commentators who advocate for an industry-funded emergency liquidity pool that would incorporate actuarially fair premiums to price the cost of systemic risk, to be paid by the largest and most complex institutions themselves. This represents a combination of ex ante and ex post approaches to inhibit systemic risk at its source as well as manage the consequences of a future systemic crisis, the costs of which would otherwise be borne again by the public and the economy as a whole.

Keywords: banking, Dodd-Frank, moral hazard, systemic risk, too big to fail, financial crisis, savings and loan crisis, financial institutions, regulation