Morally hazardous waste

As policymakers in the United States mull over new ways to regulate an ever-changing, ever-widening world financial landscape, it is important to create legislation that is not only reactive, but addresses the deeper issues of the structure of the increasingly concentrated American financial system.

Previous financial crises teach a valuable lesson - that moral hazard, or the willingness of market agents to take excessive risks with knowledge of a high likelihood of government crisis protection or intervention, is endogenous to world financial markets whether we like it or not. It's a matter of learning how to mitigate moral hazard, rather than eliminate it, that can help reduce that chances of future financial catastrophes. Most people, I think, would agree that the lessons from the current world meltdown will go largely ignored when (or if) boom times come around.

While new regulations are necessary, the Obama Administration must also look proactively at legislation passed during the last 15-20 years that have created a commercial banking sector that is, indeed, "too big to fail."

Nevermind the repeal of the Glass-Steagall Act, which once created a firewall between deposit-taking commercial banks and risk-taking investment banks - something that would have come in handy in the last few years. The Riegle-Neal Act was the most significant piece of legislation to deregulate commercial bank consolidation and provide an environment conducive to a deeper banking crisis. The Act relaxed regulations on the ability of banks to merge with other banks, leading to widespread banking mergers and the swallowing of smaller, usually state-chartered "relationship" banks into larger banks with national and international reach. The consequence was greater market concentration for the larger banks in markets nationwide.

The mergers of inefficient businesses into larger, more efficient ones in itself is not inconsistent with "economic efficiency." But when such businesses are crucial to the economy's systemic viability, such legislation should have been evaluated carefully. As banks consolidate and grow larger, a larger number of players becomes "too big to fail," leading to the impetus for larger bailouts and greater regulatory capture. In addition, when a large corporation such as Bank of America owns branches and takes in deposits in a wider range of geographies - mistakes made at the top of the corporation could have spillover effects in each of those markets where a BofA branch might be.

The Obama Administration may not wish to reverse the trend of bank consolidation - indeed, it is probably too late. But banks that have larger systemic importance should be held accountable for excessive risk-taking. A more stringent cap on market concentration would also be prudent to maintain the diversity of commrcial bank competition in markets nationwide.