Do markets still view the nation's largest banks as too big to fail? Have regulators failed to eradicate the perception that, when the next crisis comes, the government will again come to the rescue?
Given that the largest banks are now even bigger than they were before the last financial crisis, it's a pressing question. Unfortunately, a careful look at the data suggests the answer is less encouraging than many policy makers think.
Expectations of government bailouts create dangerous distortions. When, for example, creditors assume they'll get rescued in an emergency, they don't demand higher interest rates from banks that take on bigger risks. This lack of market discipline gives bankers a strong incentive -- consciously or not -- to engage in behavior that makes disasters more likely. Taxpayers effectively end up subsidizing activity that threatens their own well-being.
Ever since the giant bailouts of 2008 and 2009, regulators have been trying to solve this too-big-to-fail problem. By requiring banks to fund themselves with more loss-absorbing capital, they aim to make failures less likely. By setting up mechanisms to wind down failed banks, they hope to convince markets that governments have options other than taxpayer-backed rescues.