The financial system in the United States has been under stress since about the beginning of 2007 when the housing market began to collapse. Since 2007, hundreds of banks have been shut by the FDIC, but these banks aren’t the biggest problem in the U.S. Since the beginning of the FDIC, banks pay insurance fees to the FDIC in order to help depositors at those institutions from losing all of their money when a bank fails. However, this creates a problem for regulators since banks that take bigger risks are protected at a limited expense to any individual shareholder or employee. The problem of moral hazard exists in banking explicitly because of the FDIC, but also exists implicitly if the U.S. government stands ready to bail out any financial institution that it deems too-big-to-fail. Ben Bernanke has noted that too-big-to-fail institutions are a growing problem in the U.S., especially for large interconnected financial institutions that make very large gambles. So what should be done about the too big to fail problem?
One solution thought to help with the too-big-to-fail problem, is to adopt a Canadian type banking system where banks are large, but not necessarily too interconnected. A fundamental difference between U.S. and Canadian banks is that in Canada, people are typically forced to post 20% of the purchase price of a new home, and also purchase insurance against the possibility of failure. But as Boone and Johnson point out, the government is providing the insurance to the banks in Canada. So, the question remains, what could be done about the banking system in the United States? Should we force banks into being smaller by breaking them up? Or should we allow very large financial institutions to exist as long as they maintain a greater level of capital against their loans (in other words, the government would limit the amount of leverage that banks are able to take).