There are four ways to fix the problem with banks

• Published date: 21 March 2023

The incentives for management incline them towards risk-taking, just as the incentives for states incline them towards saving the utility when risk-taking blows it up. The result is costly instability

If one thing is clear about the events of the last two weeks, it is that the vaunted reforms introduced after the global financial crisis have not changed any of this that much, or at least not enough.

Yes, leverage of banking systems has fallen since the crisis. But it remains dangerously high. According to the Federal Reserve, on March 8th, 2023, the difference between the book value of the assets and debt liabilities of US commercial banks was $2,137 billion (€1,981 billion).

This is a slice of equity-backed assets that were notionally worth $22,800 billion (€21,167 billion). But a recent paper suggests that mark-to-market losses are already about $2 trillion. A general run would force these losses into the open, and wipe out the equity. To prevent this, the authorities may have to protect all deposits.

Nice words were uttered about the need for orderly resolution of failing banks, with equity the first claim to be wiped out. But, lo and behold, that is not what happened in saving Credit Suisse. Equity holders retained value and the state also provided them with guarantees indirectly, by guaranteeing UBS.

The notion that the government guarantee of deposits creates moral hazard is also complicated

Yet, we are told by the Swiss finance minister, "This is no bailout. This is a commercial solution." It is indeed a bailout. It might be the least costly solution overall. But this is not how the post-2008 crisis regime was supposed to work. I am not that surprised.

At this stage, it is still not clear how bad this crisis is going to be. But it is already evident that the reforms after the last one, though vastly better than nothing, were not enough, especially after the Trump administration tampered with them. They have not guaranteed a crisis-proof system. They have not provided a smooth way to resolve a bank in crisis, especially if the problem risks becoming systemic.

So what might be done? There are four broad approaches to reform.

First, let the market prevail, as Ken Griffin of Citadel has argued. Alas, the functions of the banks in providing money and credit are too vital to allow this.

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The notion that the government guarantee of deposits creates moral hazard is also complicated. Depositors are unable to...