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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