[L]ack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation – capital requirement in particular – has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators.
Update: Acharya and Richardson argue that the large financial institutions took on too much risk, and that is what made this financial panic different from past financial crunches.
This lack of risk transfer – the leverage “game” that banks played – is the ultimate reason for collapse of the financial system, in our opinion.I like the way that they proceed to ask why this crisis was not an ordinary one, but one that was extraordinary deep and wide in the financial markets.
John Taylor has his take on the crisis, and like Acharya and Richardson, is writing a book. Taylor, of the Taylor Rule, argues in The Wall Street Journal that bad government policy is the reason this crisis is so deep. Monetary policy was too easy for several years, there was excess risk taking tied to various mortgage instruments, and the Fed misread the problems that surfaced in September of 2007. The poorly-thought-out TARP program made the problem worse rather than solving it.