Former Chair of Federal Reserve, Paul Volcker notes both the need for banking industry regulatory reform and that one of the needs to address the “moral hazard” that currently exists in the system.  “Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk” according to Wikipedia.  In the case of banks, it is the phenomenon of “heads the bank wins, tails somebody else loses”.  Since widespread bank failures have economy-wide effects (see Great Depression), society, through the government, has an interest in making sure banks don’t fail.  But, knowing that failure is effectively “insured” against, banks will typically take on more risk than they otherwise would.  Figuring out how to insure depositors against loss and widespread bank failures without creating excessive moral hazard is one of the goals of any financial regulatory reform program.

PRESIDENT OBAMA 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.

Aggressive action by governments and central banks — really unprecedented in both magnitude and scope — has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession.

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A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established “safety net” undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.

via Op-Ed Contributor – How to Reform Our Financial System – NYTimes.com.