This crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.

It has often been said since the crisis began that an institution that is “too big to fail” (TBTF) is too big to exist. I agree. The question is how we can best get rid of the TBTFs without increasing the power of government in the economy still further.

Economists have long held that bank failures pose a “systemic” economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of “moral hazard” prior to 2007, little was done to disabuse big financial institutions of this notion. They could and did assume that they enjoyed an implicit government guarantee.

With the exception of Lehman Brothers, they were right. Beginning with the British Government’s takeover of Northern Rock in 2007 and culminating in the US Government’s vast injections of capital into AIG, Citigroup and other institutions, the Western world has witnessed a succession of government interventions in the banking system unprecedented other than in time of war. These measures can be justified on the ground that without them there would have been a banking crisis comparable with that of 1931, which did as much as the 1929 stock market crash to plunge the world into a Great Depression.

But there is a danger that justified emergency measures give rise to unjustifiable permanent conditions.

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All would not have been for the best in the best of all possible worlds if only Lehman Brothers had been saved. On the contrary, a decision to bail out Mr Fuld would almost certainly have had worse consequences than letting him and his company go under.

…Lehman’s chief executive persistently over-played his hand, overvaluing the property assets on the bank’s balance sheet by as much as $25bn-30bn. Mr Fuld was adamant: “As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it.”

…But there was a reason why no buyer could be found in this universe. Lehman was a firm in its death throes. It had lost $6.7bn in the space of six months. It had debts in excess of $600bn. Its assets were collapsing in value. Even when a deal with Barclays seemed within reach, the British Financial Services Authority vetoed it. Alistair Darling, the chancellor of the exchequer, made it clear: “We are not going to import your cancer.”

…Not everything in history is inevitable; contingencies abound. Sometimes it is therefore right to say “if only”. But an imagined rescue of Lehman Brothers is the wrong counterfactual. The right one goes like this. If only Lehman’s failure and the passage of Tarp had been followed – not immediately, but after six months – by a clear statement to the surviving banks that none of them was henceforth too big to fail, then we might actually have learnt something from this crisis.

The real tragedy is that the failure of Lehman has left Wall Street’s survivors both bigger in relative terms and more secure politically. As long as the big banks feel confident that they can count on the government to bail them out – for who would now risk “another Lehman”? – they can more or less ignore calls for lower leverage and saner compensation.

If only we had learnt from Lehman that no bank should be “too big to fail”, we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year’s crisis. If only.

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Niall Ferguson: The Ascent of Money: A Financial History of the World

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

A year after the near-collapse of the financial system last September, the federal response has redefined how Americans get mortgages, student loans and other kinds of credit and has made a national spectacle of executive pay. But no consequence of the crisis alarms top regulators more than having banks that were already too big to fail grow even larger and more interconnected.

“It is at the top of the list of things that need to be fixed,” said Sheila C. Bair, chairman of the Federal Deposit Insurance Corp. “It fed the crisis, and it has gotten worse because of the crisis.”

Regulators’ concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government’s backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess.

This problem, known as “moral hazard,” is partly why government officials are keeping a tight rein on bailed-out banks — monitoring executive pay, reviewing sales of major divisions — and it is driving the Obama administration’s efforts to create a new regulatory system to prevent another crisis. That plan would impose higher capital standards on large institutions and empower the government to take over a wide range of troubled financial firms to wind down their businesses in an orderly way.

“The dominant public policy imperative motivating reform is to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy,” Treasury Secretary Timothy F. Geithner said in an interview.

The worry for consumers is that the bailouts skewed the financial industry in favor of the big and powerful. Fresh data from the FDIC show that big banks have the ability to borrow more cheaply than their peers because creditors assume these large companies are not at risk of failing. That imbalance could eventually squeeze out smaller competitors. Already, consumers are seeing fewer choices and higher prices for financial services, some senior government officials warn.

Those mergers were largely the government’s making. Regulators pushed failing mortgage lenders and Wall Street firms into the arms of even bigger banks and handed out billions of dollars to ensure that the deals would go through. They say they reluctantly arranged the marriages. Their aim was to dull the shock caused by collapses and prevent confidence in the U.S. financial system from crumbling.

Officials waived long-standing regulations to make the deals work. J.P. Morgan Chase, Bank of America and Wells Fargo were each allowed to hold more than 10 percent of the nation’s deposits despite a rule barring such a practice. In several metropolitan regions, these banks were permitted to take market share beyond what the Department of Justice’s antitrust guidelines typically allow, Federal Reserve documents show.

“There’s been a significant consolidation among the big banks, and it’s kind of hollowing out the banking system,” said Mark Zandi, chief economist of Moody’s Economy.com. “You’ll be left with very large institutions and small ones that fill in the cracks. But it’ll be difficult for the mid-tier institutions to thrive.”

“The oligopoly has tightened,” he added.

Consumer Choice

Federal officials and advocacy groups are just beginning to study the impact of the crisis on consumers, but there is some evidence that the mergers are creating new challenges for ordinary Americans.

In the last quarter, the top four banks raised fees related to deposits by an average of 8 percent, according to research from the Federal Reserve Bank of Dallas. Striving to stay competitive, smaller banks lowered their fees by an average of 12 percent.

“None of us are saying dismember these institutions. But you do want to create a system that allows for others to grow, where no one has an oligopolistic power at the expense of others who might be able to provide financial services to consumers,” said Richard Fisher, president of the Federal Reserve Bank of Dallas.

Normally, when faced with price increases, consumers simply switch. But industry officials said that is not so easy when it comes to financial services.

In Santa Cruz, Calif., Wells Fargo, Bank of America and J.P. Morgan Chase hold three-quarters of the deposit market. Each firm was given tens of billions of dollars in bailout funds to help it swallow other banks.

The rest of the market, which consists of a handful of tiny community banks, cannot match the marketing power of the bigger banks. Instead, presidents of the smaller companies said, they must offer more personalized service and adapt to technological changes more quickly to entice customers. Some acknowledged it can be a tough fight.

Wells Fargo is “really, really good at the way they cross-sell and get their tentacles around you,” said Richard Hofstetter, president of Lighthouse Bank, whose only branch is in Santa Cruz. “Their customers have multiple areas of their financial life involved with Wells Fargo. If you have a checking account and an ATM and a credit card and a home-equity line and automatic bill payments . . . to change that is a major undertaking.”

Wells Fargo, J.P. Morgan and Bank of America declined to comment for this article.

Last October, when the Fed was arranging the merger between Wells Fargo and Wachovia, it identified six other metropolitan regions in which the combined company would either exceed the Justice Department’s antitrust guidelines or hold more than a third of an area’s deposits. But the central bank thought local competition in each of those places was sufficient to allow the merger to go through, documents show.

Camden Fine, president of the Independent Community Bankers of America, said those comments reveal the government’s preferential treatment of big banks. He doubted whether the Fed would approve the merger of community banks if the combined company ended up controlling more a third of the market.

“To favor one class of financial institutions over another class skews the market. You don’t have a free market; you have a government-favored market,” he said. “We will never have free markets again if you have the government picking winners and losers.”

Moral Hazard

Before the crisis, many creditors thought that the big institutions were a relatively safe investment because they were diversified and thus unlikely to fail. If one line of business struggled, each bank had other ventures to keep the franchise afloat. And even if the entire house caught fire, wouldn’t the government step in to cover the losses?

With executives comforted by that thinking, risk came unhinged from investment decisions. Wall Street borrowed to make money without having enough in reserves to cover potential losses. The pursuit of profit was put ahead of the regard for safety and soundness.

The federal bailouts only reinforced the thought that government would save big banks, no matter how horrible their decisions.

Today, even with the memory of the crisis fresh in their minds, creditors are granting big institutions more favorable treatment because they know the government is backing them, FDIC officials said.

Large banks with more than $100 billion in assets are borrowing at interest rates 0.34 percentage points lower than the rest of the industry. Back in 2007, that advantage was only 0.08 percentage points, according to the FDIC. Such differences can cause huge variance in borrowing costs given the massive amount of money that flows through banks.

Many of the largest banks reported a surge in profit during the most recent quarter, including J.P. Morgan Chase and Goldman Sachs. They are prospering while many regional and community banks are struggling. Nearly three dozen of the smaller institutions have failed since July 1, including Community Bank of Nevada and Alabama-based Colonial Bank just last week.

If the government continues to back big firms over small, regulators worry that reckless behavior could return to Wall Street.

The administration’s regulatory reform plan takes aim at this problem by penalizing banks for being big. It would require large institutions to hold more capital and pay higher regulatory fees, as well as allow the government to liquidate them in an orderly way if they begin to fail. The plan also seeks to bolster nontraditional channels of finance to create competition for large banks. If Congress approves the proposal, Geithner said, it would be clear at launch which financial companies would face these measures.

Economists and officials debate whether these steps would address the too-big-to-fail problem. Some say, for instance, that determining the precise amount of capital big financial companies should hold in their reserves will be difficult.

Geithner acknowledged that difficulty but said the administration would probably lean toward being more strict. Taken together, the combination of reforms would be a powerful counterbalance to big banks, he said.

“Our system is not going to be significantly more concentrated than it is today,” Geithner said. “And it’s important to remember that even now, our system remains much less concentrated and will continue to provide more choice for consumers and businesses than any other major economy in the world.”