The repeal of Glass-Steagal led to the formation of Too Big To Fail banks. It mingled the safe, boring banking with the risky, speculative banking. When the speculative activities of these behemoth financial institutions put them at risk of collapse, the government was left with a dilemma. Do we follow market principles and let the banks fail, risking a seize-up of the entire banking system, or do we step in and bail them out, adding to our national debt and increasing moral hazard?
The financial crisis isn’t just the collapse of the housing bubble and Lehman, it includes the depression that followed. We couldn’t deal with what happened in the same way we dealt with the S&Ls. The S&L crisis cost us quite a bit, but no major depository institutions were in danger of failing, the market share of S&Ls was brought down to a more reasonable level, people were prosecuted, and the broader banking industry continued on as before. But this time was different. With the financial institutions being so large, there wasn’t the political will to break off the healthier parts from the insolvent parts, mainly because of the fear that it would collapse the entire economy. So we had to bail them out, rotten parts and all. They’re still in business, and they’re still fundamentally rotten at their cores (rotten financially, not to mention ethically). And if they screw up again, there’s every expectation that we’ll bail them out again, resolution authority be damned. When the market can’t be sure that the banking system is fundamentally healthy, that makes any economic recovery tenuous.