Martin Wolf makes it--effectively--in his latest column:
In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors [Lucian Bebchuk and Holger Spamann of Harvard Law School] argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”.
Think of two business models with the same expected returns: in one these returns are sure and steady; in the other the outcome consists of lengthy periods of high returns and the occasional catastrophic loss. Rational shareholders will prefer the latter. This is what one sees: high equity returns, by the standards of other established businesses, and occasional wipe-outs. ...
A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.
Like Paul Krugman, I'm skeptical that you can solve the moral hazard problem by shrinking institutions (though I'd like to shrink them for other reasons). It's just not clear you can shrink them enough to get the job done and still have credit as cheap and available as you need for a massive economy. I don't even get the sense that Wolf thinks it's possible.
He nonetheless seems to think you can alter the incentives management, shareholders, and bondholders face so as to mitigate the moral hazard problem, though he doesn't say how. Maybe one thought is to let it be known that bondholders won't be wiped out if an institution fails, but that they will take a meaningful haircut, which would force up interest rates a bit and limit leverage.
--Noam Scheiber