By Simon Johnson

Who was more wrong in the run-up to the financial crisis of 2008: the Federal Reserve or Moody's Investors Service? This isn't an academic question; both organizations are still hugely relevant to shaping the way we see our financial system and the risks it contains. And both are now apparently underestimating the dangers again.

To be fair, the thinking at both places has shifted, but not anywhere close to enough. The reason for this is simple: The incentives that encouraged their misperceptions before 2008 remain in place today.

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Before 2008, the Fed was exuberant about modern finance and its complexity. Chairman Alan Greenspan's line was that if the market favored an innovation, then that innovation should be allowed or even encouraged, regardless of the potential negative consequences.

In 2007, as chief economist of the International Monetary Fund, I attended many meetings with senior Fed officials. In retrospect, they had a good grip on what was happening with house prices and the buildup of debt in households.

But they had a blind spot when it came to derivatives — in particular the way in which implied risks had become concentrated in a relatively small number of financial institutions, and what could happen when these came under pressure. Part of the reason for this blind spot was — and is — structural. It results from the oversize importance of the New York Fed in the Fed system, and the longstanding cozy relationship between the New York Fed and the elite of Wall Street.

Major Shift

This isn't a new problem — it has reared its ugly head several times since the founding of the Fed 100 years ago. But complacency among this set of officials was a major part of what went wrong in 2007 and 2008. Bill Dudley, the current president of the New York Fed, is a former Goldman Sachs Group Inc. executive who is clearly somewhat conflicted about what he has seen in recent years.

In a speech on Nov. 7 at the Global Economic Policy Forum in New York, he said some large financial institutions had "the apparent lack of respect for law, regulation and the public trust. There is evidence of deep-seated cultural and ethical failures at many large financial institutions."

These are unusual and commendable comments for the New York Fed. And Dudley was candid that big banks are able to borrow more cheaply as a result of potential official support.

He said research by the New York Fed "shows that the funding advantage of large versus small banks is higher than the funding advantage for large versus small non-bank financial firms and non-financial firms when other factors are held constant."

Yet there was a major flaw in his speech. Dudley placed great emphasis on the new resolution rules for failing big financial companies, a reference to the mechanism through which the Federal Deposit Insurance Corp. would take over such institutions without disturbing markets. Dudley completely ignored the legal requirement of the Dodd-Frank Act that all financial companies should be able to go bankrupt without support from the official sector and without disrupting the world economy. That's the point of the living wills.

The resolution authority is only supposed to provide a backup, in case the living wills prove inadequate. If the New York Fed has given up on living wills, that would be a major policy shift by regulators and a show of disregard for the intent of the Dodd-Frank legislation. It also fits the public relations campaign by the big banks, spearheaded by the Clearing House Association, that is communicating the subliminal message of "Don't worry, we have fixed the problem of too big to fail."

Reduced Support

Unfortunately, Moody's — which does a great deal of credit-rating business with big Wall Street entities — swallowed this line. Its recent statement says the degree of government support for large financial institutions is reduced. Most remarkably, "Moody's reduced the uplift that had been incorporated into the subordinated debt ratings of the eight banking groups' operating subsidiaries."

But the degree of uplift — meaning the protection extended in downside scenarios — for creditors to operating subsidiaries has actually increased under the FDIC's so-called single point of entry resolution plan. (I serve on the FDIC's Systemic Resolution Advisory Committee, but this assessment here represents my views only.)

Creditors to the holding company may be more on the line — but only if there is enough equity and "bail-in-able" debt to absorb losses. Moody's takes a big leap of faith on this point because bail-in-able debt is the latest unicorn of finance: a mythical creature with magical properties. The approaches to bank resolution of the FDIC and the Fed will only work if living wills are a practical reality.

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The cost of funding for bank holding companies should increase (Moody's is right on this point), but the Fed must limit the amount of debt at operating subsidiaries, which are now receiving larger implicit subsidies. Unfortunately, Moody's and the Fed are encouraging each other once again to misunderstand financial sector risks.

Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You."