Strengthening Our Financial System

September 24, 2013

Incentives matter and the incentives toward risk taking among the largest financial firms remain basically unchanged from pre-financial-crisis times. Despite the enormous regulatory burdens placed on financial firms post-Dodd-Frank, these firms continue to be driven toward leverage. With time, we can be confident that our financial system will once again become highly leveraged and the economic system will become more fragile as a result, says Thomas M. Hoenig, vice chairman of the Federal Deposit Insurance Corporation and a former president of the Federal Reserve Bank of Kansas City.

To change outcomes, you must change incentives. With the safety net, you alter the market's incentives, create moral hazard, and drive toward leverage that creates its own set of adverse consequences.

Three steps to be taken to control these negative effects:

  • Limit the safety net's protection.
  • Simplify and strengthen capital adequacy standards.
  • Improve bank supervision.

We will never end financial crises. Capitalism and fractional reserve systems are very successful systems, but they also are volatile. However, we can contain the effects of the volatility and make these firms more accountable for their actions. Simplifying and strengthening capital standards and improving supervision of the largest, most complex firms are steps in that direction. Furthermore, if we expect the market to drive outcomes, then we must narrow the safety net's coverage of liabilities and increase the ability for the market to identify and deal with these firms without the government's ever expanding support.

Source: Thomas M. Hoenig, "The Case for Simple Rules and Limiting the Safety Net," Cato Journal, Fall 2013.

 

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