Trump Wants to Unleash the Banks. End the Bailout Culture First.
The stakes couldn’t be higher as President Trump’s nominees and advisers signal the new administration’s intent to roll back financial regulations. If done correctly, financial deregulation can spur entrepreneurship, boost economic growth, and increase wages. But if mishandled, it risks destabilizing the financial system and triggering a crisis on a scale that could dwarf 2008.
To understand the challenge, imagine a tug of war over a bank’s risk-taking. On one side, some executives and board members pull for high-risk, high-return strategies, enticed by the large payouts if those investments succeed. On the other side, investors with significant exposure to losses pull for prudence. But what happens when those advocating for caution let go of the rope? The result is excessive risk-taking, with dire consequences for financial stability.
Why would influential investors with significant exposures stop advocating for caution? The reason stems from a concept economists call “moral hazard.” When decision makers share the upside of risky bets but are shielded from the downside, they have little incentive to act prudently. In a healthy financial system, investors who stand to lose from a bank’s failures constrain excessive risk-taking. However, when these investors believe government bailouts will rescue them when things go wrong, they stop pulling for caution and join the side advocating for more risk.
Unfortunately, moral hazard has become entrenched in the U.S. financial system. Over the years, federal regulators, including the Federal Reserve, have repeatedly bailed out investors—sometimes even uninsured or nondeposit investors in large financial institutions. The Dodd-Frank Act was passed after 2008 to prevent another similar financial crisis. Instead, the law has unintentionally worsened the risk-taking dynamics in the financial sector. By codifying the Federal Reserve’s responsibility for all “systemically important” financial institutions, the act has effectively extended the protective bailout net, encouraging ever-riskier behavior.
The collapse of Silicon Valley Bank in March 2023 underscores this problem. Although many of the banks’ deposits exceeded the threshold for government guarantees, the authorities opted to make all depositors whole. That decision again signaled that even uninsured investors can expect to be bailed out the next time a bank fails. This only deepens the moral hazard problem, incentivizing banks to take greater risks, knowing that others will shoulder the losses.
The current regulatory approach attempts to counteract the powerful risk-taking incentives unleashed by government bailouts by constructing a vast regulatory and supervisory apparatus. But this comes with enormous costs. The apparatus burdens financial institutions with significant compliance costs that are ultimately passed to the public, and it impedes the efficient allocation of credit, slowing economic growth.
While deregulation seeks to alleviate these adverse effects, it must be approached cautiously. Rolling back regulatory constraints on risk-taking without addressing the root cause of moral hazard—bailout expectations—would only exacerbate the problem. It would loosen the grip of regulators pulling for prudence without replacing it with the steady hands of private investors duly incentivized by having their wealth on the line. A similar mismanagement of the timing of financial deregulation contributed to the 2008 crisis and numerous other financial crises worldwide.
What’s needed is a credible strategy to ensure that decision makers within financial institutions have genuine “skin in the game.” This means reforming policies that shield influential investors and executives from the consequences of their actions, exposing them to potential losses. Such reforms would realign incentives, restoring the natural tension that constrains excessive risk-taking.
Credibility is key. Regulators and policymakers can’t simply promise not to bail out uninsured investors. Investors won’t believe them because officials have repeatedly shown that they will bail out just about everyone when things go awry. If investors don’t believe they are exposed to potential losses, they won’t pull for prudence. They will continue to advocate excessively high-risk strategies, expecting the government to bail them out if those gambles fail. Without credibility, the tug of war over risk will remain dangerously imbalanced.
By aligning incentives before loosening restrictions, the administration can create a robust and dynamic financial system. Research consistently shows that well-executed deregulation can boost entrepreneurship, drive job creation, and improve living standards—especially for the middle class. But the sequencing matters. If deregulation is rushed without addressing moral hazard, the consequences could be catastrophic.
The choices made in the coming months regarding the sequencing of financial deregulation will shape the U.S. economy for decades. Getting it right could encourage growth and prosperity. Getting it wrong risks repeating a key mistake that underpinned the 2008 crisis, with devastating consequences for economic and social stability.