Second, determine what is systemic -- in other words, what is potentially a large enough threat to financial markets and the economy. If something is systemic, as our banking system is, then there is a strong case that it needs to be regulated. That is why banks are subject to liquidity and capital requirements, and why they provide deposit insurance and pay premiums for it. If sources of systemic risk were regulated, then risk would not only be lower, but the regulated entities more fully would bear the costs of their actions.
Third, one might consider requiring systemic non-bank financial institutions and illiquid investment funds to buy Fed liquidity insurance. That would both account for the costs of their risk-taking and limit future moral hazard. Also, it would make financial crises less severe, lowering the risk of runs because such entities would have explicit access to the Fed’s liquidity.
None of these changes would be easy to implement. Unfortunately, when the crisis fades, the pressure to adopt reforms will wane. Nevertheless, the moral hazard issue needs to be debated and addressed. Big crises seem to be occurring more often and Fed interventions are growing ever bigger in size and broader in scope. Whatever you thought was the size of the moral-hazard problem before, now it’s gotten even larger.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
This column was provided by Bloomberg News.