The huge bank bailouts under way across the industrial world make the point: governments cannot allow banks to fail for fear that the collapse of one will provoke a systemic crisis. By extension, perhaps government guarantees played a central role in creating the mess, so reforming them will be key to preventing a recurrence.
Consider the role played by guarantees in encouraging banks to operate with high levels of leverage prior to the crisis. The market believed that their liabilities – not just customer deposits but also their uninsured public debt – were guaranteed by government regulators. This kept the price of their borrowing artificially low: banks with leverage to assets ratios of 80% or 90% were able to borrow at just 20 basis points more than government bonds.
