Mr. Reinhart said the bailout "eliminated forever the possibility the Fed could serve as an honest broker." In 1998, the Fed coaxed private creditors of Long-Term Capital Management to bail out the hedge fund but didn't have to put up its own money. If it ever tries a similar maneuver on a Wall Street cohort, he said, "The reasonable question any person in the room will ask is, 'How much will you contribute to the solution?'"

Brad DeLong looks at the same issue and concludes

We now have two precedents. If the Federal Reserve judges that a major financial institution:

* is too big to fail in that its failure will generate systemic risk
* has followed portfolio strategies that have produced inappropriate and excessive leverage
* requires immediate action

then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero equity.

It doesn't solve the incentive problem completely, though. Yes, if the shareholders are left with nothing, the moral hazard problem doesn't apply to them. But it does to the managers - they're still left with asymmetric rewards, as I've discussed before.

The alternative is to ask: why should we let banks get "too big to fail?" Why not simply impose exposure limits - not capital requirements, which can be gamed, but hard limits, backed by sanctions - set as a maximum possible share of the market? The government's already in the business of deciding when banks (and other companies) are too big - by permitting or forbidding mergers that would give a single entity too much influence over its market, and by forcibly breaking up monopolies. All we need to do is focus in a little more, and we can avoid future equivalents of the discovery of Bear Stearns' huge CDS counterparty position.