From Country Banks to SIFIs: The 100-year Quest for Financial Stability

The federal financial “safety net” covers 60 percent of the financial system’s liabilities, according to Richmond Fed economists. The safety net creates moral hazard, thus encouraging firms perceived as “too big to fail” and arguably making the financial system less stable. Ironically, the origins of “too big to fail” stem from a series of decisions intended to protect small banks. Moral hazard was exacerbated by a series of rescues by the Federal Reserve and the FDIC that began in the 1970s and by policymakers’ actions during the financial crisis of 2007–08. Regulation alone is unlikely to contain moral hazard. Instead, solving the fundamental problem at the heart of “too big to fail” requires restoring market discipline. Strategies to restore market discipline include resolution planning for large financial firms and limiting the power of government agencies to intervene.