In 1980, a group of economists called the Gramm-Leach-Bliley Act made it legal for the banks to “offshore” their deposit-taking operations and leave them in place on a subsidiary or local level. This allowed the banks to shift much of their lending to a regionally based bank, taking the deposits and outsourcing risk. Many of these local banks had the perfect combination of regulatory clarity and low cost of operations—and so the banking crisis loomed.
Meanwhile, the U.S. government was considering a system of bailouts. According to “How Financial Systems Fail,” a 2007 paper by Nobel laureate Robert Shiller, a key aim of Treasury policy at the time was to restructure its role in the banking sector so that it no longer intervened directly as a lender of last resort. Initially, this policy would be more focus on getting rid of the complicated structures of a depository and a lending institution, and leaving the difference—the riskiness—to the private sector. Since the recovery from the Great Depression had been hampered by a collapse in moral hazard and the failure of private companies to lend to the general public during the first three years, this was a sound approach.
Bailouts are typically considered failure prevention measures, and therefore must focus on maximizing stability rather than maximizing gain. But bailouts have a nasty side effect that has been difficult to avoid: they cause potential bank failure to become a problem of re-pricing risk, rather than simply a matter of rapid loss-absorption capacity.
After the 2008 financial crisis, bailouts became a main source of funding for financial firms. To stay viable, firms that had suffered large losses in recent years began to reprice their risks, prompting re-estimation of their solvency and equity provisions. As a result, the cost of funding to banks escalated and the yield curve steepened. Banks that were exposed to higher borrowing costs than those with stronger balance sheets were bound to become financially weaker. Bailouts were meant to ensure that large financial firms remained viable while re-pricing risk.