Bailout dangers were on the radar of the Minneapolis Fed long before Kashkari's arrival

Neel Kashkari was 24 and finishing a master's degree at the University of Illinois when two economists at the Federal Reserve Bank of Minneapolis argued that government protections for "too big to fail" banks were too sweeping, and encouraged reckless risk-taking.

The year was 1997.

Ever since the savings and loan crisis of the 1980s, thinkers at the Minneapolis Fed have been sounding the alarm over moral hazard, the economic distortion that arises when lenders and their creditors believe the government will bail them out in a crisis.

It's a hazard Kashkari, who will become president of the Minneapolis Fed in January, confronted in the biggest role of his professional life: running the largest bailout in U.S. history. "To save the economy, we had to violate a core American principle: You bear a risk, you suffer the consequences," Kashkari told the Wall Street Journal in 2013.

Now Kashkari is taking the reins of the regional Federal Reserve bank that has been at the forefront of research into the cycle of financial crises and bailouts, a problem of expectations that is far from solved.

"This is the bank that did some of the pathbreaking work on this and hopefully will influence policy in this area going forward, and I think given his background in Treasury during this time, he could be a major player in the future regulatory framework that we put around these banks," said Arthur Rolnick, the Minneapolis Fed's research director from 1985 to 2010.

Few economists studying the problem would argue the government erred in rescuing the financial system in 2008, but the bailouts did nothing to dissuade financial companies from the notion that the federal government would save them from their own mistakes.

That belief is the subject of a 2004 book by former Minneapolis Fed President Gary Stern and Ron Feldman, still a top economist at the bank. In the book, titled "Too Big to Fail: The Hazards of Bank Bailouts" and not widely read before the financial crisis, they argued that "not enough has been done to reduce creditors' expectations of TBTF protection."

They were right then and still are. People who owned stock lost money in the crisis, but the bailouts saved bondholders and other creditors whose lending allows banks to keep operating.

Feldman says that thanks to the Dodd-Frank Act of 2010 and other regulatory measures, useful reforms are in motion, much of them in line with what he and Stern recommended in 2004.

Banks have more capital to cushion losses, and regulators are making progress on how to unwind a failing bank without letting its failure spread to other banks, which was the great fear in 2008. But many of the reforms are only now being put in place, he said, and the complexity of financial crises demands ­humility from policymakers.

"Is there a huge task ahead of us in implementing this? Absolutely. Will there be a huge task when we're faced with it? Absolutely," Feldman said. "We're not going to really know until we're faced with the choice about what we're going to do."

The expectation of a rescue contributed to bankers' failure to closely investigate securities backed by subprime mortgages, the financial products that caused the 2008 crisis. Major investment banks collapsed and, with the global credit system on the brink of failure, the Bush administration and Congress created the $700 billion Troubled Asset Relief Program, with Kashkari in charge.

"Once a crisis has hit and once people have become highly indebted, then not doing a bailout can be extremely damaging," said V.V. Chari, an ­economist at the University of Minnesota and the Minneapolis Fed. "The right question has got to be, beforehand, how do you think about setting up a regulatory system so that you don't end up in that kind of mess."

Chari published a working paper with Patrick Kehoe in August arguing that regulators should impose new debt-to-equity ratio limits on financial institutions and tax them according to their size as a way to prevent them from taking on too much risk.

"We need to have the ammunition ready well before the next financial crisis hits," Chari said. "I still think that there's a big opportunity here, and I hope he picks that up and runs with it."

The fit would be a natural one for Kashkari — he discussed moral hazard constantly in 2008. But he hasn't publicly laid out an agenda for his new job in Minneapolis.

"I don't come into this job saying here are the top three things we have to do," he said last week. "I come into this job saying here are all the folks that I want to meet with and learn from and hear from and incorporate their views so that we are using our time most productively and our resources most productively."

Adam Belz • 612-673-4405 Twitter: @adambelz