Recognize that banking . . . is a disaster-prone 19th century technology. The [banking] problem is unsolved now, nor will it ever be, I’m afraid, given the moral hazards posed by the absurdly high leverage ratios in banking, by deposit insurance, by the doctrine of “too big to fail,” and by the increasing likelihood that the IMF—at least until it runs out of money—always stands ready in the wings to bail out bad banks and bad creditors generally.
—Prof. Merton Miller1
None of the risks to which banking is prone can be avoided entirely. As was observed earlier, they can only be minimized, mitigated, or optimized—in other words, managed.2
Left to their own devices banks may behave in ways that increase their already considerable risks. Were the concomitant costs borne solely by the bank’s owners, as is the case with ordinary commercial enterprises, such high-risk behavior would be of little concern to policy makers. But, as must already be evident, banks differ in material respects from their corporate counterparts, and imprudent risk taking on the part of banks poses severe risks to the economy as a whole. Imprudently managed banks are prone to conflict with and undermine government’s economic policy goals, and the failure of one or more major institutions can catalyze a crisis that paralyzes the entire financial system.3
Governments have therefore learned (and sometimes forgotten again) the benefits of placing strict constraints on bank ...