The similarities between deposit runs and short-term wholesale funding runs have suggested to some that the policy responses should also be similar. Those taking this position argue for providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale funding, or both. Others, myself included, are wary of any such extension of the government safety net and would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding. Unlike deposit insurance, the savings of most U.S. households are generally not directly at risk in short-term wholesale funding arrangements. And, also unlike insured deposits, there is an argument in the short-term wholesale funding context that counterparties should be capable of providing some market discipline in at least some of the contexts in which such funding is provided.

Important as it is, moral hazard is not the only worry engendered by very large, highly interconnected firms in financial markets. Assuming that a government overcomes time-consistency problems and credibly binds itself not to rescue these institutions, their growth would presumably be somewhat circumscribed. But it is possible, perhaps likely, that some combination of scale and scope economies, oligopolistic tendencies, path dependence, and chance would nonetheless produce a financial system with a number of firms whose failure could bring about the very serious negative consequences for financial markets described by the domino and fire-sale effects.

[Despite provisions in the Dodd-Frank bill,] the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net.

Instead of more regulation, we need better-designed regulation that recognizes incentives and tries to address moral hazard so that market discipline can work. Overly proscriptive regulation is counterproductive - it increases the incentives to evade it, which ultimately defeats it. Financial innovation spurred by the desire to evade regulation and relocating activities outside of regulation’s reach are not productive, but they are an expected outcome if regulations are not well designed. Market discipline is an essential part of our market-based economy, and regulation should be designed to enhance it, not thwart it.

This requires scaling back some of the safety net subsidies that have risen over the years and increasing capital requirements.

I have some concerns that holding securities with risky payoffs on the Fed’s balance sheet creates the potential for moral hazard. If market participants believe that the Fed is immune to the poor payoffs from these assets and the Fed’s plans for these assets is not clear, the economics of moral hazard suggest that the central bank may have incentives to take on excessive risks at the expense of taxpayers.

For the financial industry, your core challenge is to restore the trust and confidence of the American people and your customers and investors around the world.

You will have to make your own decisions about how best to do that, but, I thought, given that I'm here in New York, I'd offer a few suggestions as an interested observer...

Focus on improving your financial position so that your financial ratings, your cost of capital, the amount you have to pay to borrow, all reflect your own financial strength and earnings prospects, not the false expectation that the government will be there in the future to rescue you.

My view is that no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers—for the best of reasons—to bail out financial firms. In other words, no legislation can completely eliminate bailouts...

So, that’s my first point: Bailouts are inevitable during financial crises. Let me move to the second: Anticipation of bailouts creates inefficiency in the allocation of real investment...

...

As in the pollution case, using taxes to discourage excessive risk saves the government from actually trying to solve the cost-minimization problem of financial firms...

Here’s what I have in mind. Suppose that, for every relevant financial institution, the government issues a “rescue bond.”  The rescue bond pays a variable coupon equal to 1/1,000 of the transfers made from the taxpayer to the institution or its stakeholders. (I pick 1/1,000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero, because bailouts aren’t necessary and so the firm will not receive transfers. However, just like the institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In a well-functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the firm and its stakeholders. Thus, the government should charge the financial firm a tax equal to 1,000 times the price of the bond. Note that the “rescue” bond is only a measurement device. In particular, it is not part of the financial firm’s rescue. 

Notice that this approach could be used for a wide variety of financial institutions, including nonbanks. In principle, the government need not figure out in advance exactly which are systemically important and which are not. Instead, it could simply issue a rescue bond for every institution. Then the market itself could reveal how systemically important each institution is through the price of its rescue bonds. Of course, markets are not always perfect. It may not always be appropriate to rely only on market measures to compute the appropriate taxes. However, even in these cases, the prices of rescue bonds would contain valuable information that should be an important input into the supervisory process.

Although the sovereign debt crisis in Europe may have appeared to erupt virtually overnight, its origins were long in the making. For years many market participants had assumed that an implicit guarantee protected the debt of euro-area members. For a number of euro-area countries, including those most under pressure now, this presumption may have led to a systematic underpricing of risk, which made debt cheaper to issue than it probably should have been. Although strictures against excessive fiscal deficits and debts were built into the Maastricht Treaty, the European Union (EU) has had relatively weak mechanisms to enforce them, as EU officials themselves have recently acknowledged.

Some have well illustrated the responses associated with the recent crises to an emergency crew acting to save a burning home before it destroys the entire neighborhood. I agree that acting to save the neighborhood was important. However, to extend the metaphor, if the fire was started by a homeowner who ignored fire codes and smoked in bed, should the neighbors be required to rebuild the home at twice its original size at their expense?

www.wrightson.com/federal_reserve/fedspeak/item/4587

The Federal Reserve's response to this crisis in providing liquidity and support to institutions and markets outside of its traditional purview has been significant, creative and timely.
However, in stepping outside its normal sphere of operations and making decisions about which markets and institutions to support, the Federal Reserve has also moved into credit-allocation decisions which are more properly performed by the marketplace itself and by fiscal authorities when necessary.  These decisions have also caused the Federal Reserve to greatly expand its balance sheet and have almost certainly set expectation for similar responses in any future crises.  All of this will make it more difficult for the Federal Reserve to quickly remove its policy accommodation in the future and, thereby, will subject it to new tests of its independence as a monetary authority.

A certain degree of ambiguity...I would hope, could help temper moral hazard concerns.

As reported by Reuters.

[M]arket discipline is not now a credible check on the risk-taking of these firms; indeed, a critical plank of current policy is to assure creditors of TBTF (too-big-to-fail) institutions that they will not bear losses. Given the magnitude of the crisis, I have supported the steps taken to stabilize the financial system by expanding the safety net, but I am also acutely sensitive to the moral-hazard costs of these steps and have no illusion that losses experienced by equity holders and management will somehow resurrect market discipline.

If systemic risks at large financial institutions are particularly protected by the safety net of government credit, then such institutions will have an extra incentive to acquire precisely those risks. This may be why the unexpectedly large exposures of large banking organizations to home-mortgage-related risks stemmed from their provision of backstop liquidity commitments to a wide array of off-balance-sheet securitization arrangements. Institutions that are viewed as too big to fail may have had a comparative advantage in supplying contingent liquidity that was most likely to be needed in the event of dire macroeconomic shocks because those are the circumstances most likely to elicit broad-scale government lending support.

In 1983, John Kareken of the University of Minnesota and the Minneapolis Fed described financial deregulation as “putting the cart before the horse,” suggesting that expanding the powers of banking and thrift institutions without appropriate attention to design of the financial safety net could be a risky move.⁶ His analysis was prescient, given the savings and loan debacle that followed later in that decade. Karaken’s emphasis was on deregulation in the presence of deposit insurance, but in the current episode, lending by the Fed and the Treasury has become just as important a part of the federal financial safety net.

The striking feature of central bank lending and other government financial support during the recent turmoil is the extent to which it has extended well beyond the boundaries that previously were understood to constrain such lending, both in the range of institutions and the contractual terms on which credit has been provided. Intervention has been driven by a desire to prevent damaging disruptions to financial markets, and thus reduce the overall costs of the turmoil. While this objective is clearly understandable, central bank lending can create the expectation that similar support will be forthcoming when market disruptions occur in the future. Such expectations can themselves be very costly, because they can distort the incentives faced by, and as a result, the choices made by private-sector participants. For example, in the past year, expectation of official support may have induced some firms to take the risk of turning down capital infusions or merger offers in hopes of finding better terms in the future. Prospective equity investors may have demanded stiffer terms to compensate for the possibility of dilutive government intervention.