ECONOMIC REPORT OF THE PRESIDENT

are due in part to information asymmetries, which are not necessarily
characteristics of a large financial sector. Distortions stemming from
inefficient consumer behavior may be due to a lack of information or
insufficient consumer protection. Thus, carefully considered regulation
that focuses on eliminating distortions will improve the overall system.
The goals of such reforms should not necessarily focus on the size of
the financial system or individual institutions per se. Reforms should
instead focus on the reduction of market distortions so that resources
find their most productive use, which may or may not impact the size of
the financial sector.
these methods has benefits and drawbacks and may be used in combination
to lower the systemic risk posed by run risk.
One notable risk of insurance schemes, lenders-of-last-resort, or the
widespread belief that the government will not allow a particular financial
firm to fail is the moral hazard it introduces into the behavior of both
consumers and firms. Consumers may be less careful in the selection of
financial institutions or even seek high-risk firms that offer higher returns
because, if the firm fails they will be compensated by a government-backed
insurance scheme. The firm is incentivized to take more risk because resulting
profits may be retained while losses are born by the insurance provider.
The incentive to engage in such behavior becomes stronger the closer the
firm comes to failing. This is similar to what occurred during the savings
and loan (S&L) crisis of the 1980s and 1990s that resulted in the failure of
almost one-in-three S&L institutions. Depositors were unconcerned about
risky loans and investments made by S&Ls because the Federal Savings and
Loan Insurance Corporation insured their deposits. Such insurance schemes
protect against bank runs and may also reduce the problem of a single firm’s
failure posing significant risk to the larger financial system; however, deposit
insurance also requires rules to reduce incentives to take on too much risk
and continual monitoring for compliance.
Financial regulation can also be necessary to correct for specific market
imperfections or failures that reduce consumer welfare. These include
consumers having inadequate information available to make well-informed
decisions, agency costs, and the difficulties consumers face in assessing
the safety and soundness of financial institutions. Many of these problems
arise because of the information advantage held by financial institutions
and because financial contracts are long-term in nature. This results in the
inability of the consumer to ascertain the quality of a contract at the time
of purchase, potential moral hazard that may emerge in that the behavior
360 | Chapter 6