The U.S. government appears to be committed to supporting any large bank that
gets into trouble. A bailout environment distorts risk assessments. Debt capital
flows more readily to large institutions, even inefficient ones, than to small
ones. This article proposes reforms to the U.S. financial system. A change in
incentives is needed. Phasing out the deductibility of interest on all business
tax returns would reduce the incentive for leverage. Another reform would
require all banks to issue 10-year subordinated notes, which would provide a
large capital cushion. Banks would have to go to market every year to replace
maturing subordinated debt, which would greatly enhance market discipline.
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