First, assume omniscient regulators

From an editorial Thursday by the WSJ

Hope vs. Financial Experience
Next time, we're told, the regulators will have 20-20 foresight.

The main idea behind the Obama Administration's new financial revamp is essentially this: With more power and a modest reshuffling of the bureaucratic furniture, the same regulators who missed the last credit mania will somehow prevent the next one. If nothing else, this concept is certainly true to President Obama's campaign theme of "hope."
...
For all of its systemic worry, the Treasury proposal doesn't really address the biggest cause of risky financial business: the fact that some institutions have become too big to fail. ...

The danger is that once the market understands these banks are too big to fail, the banks themselves and their lenders will begin to consider them to be like Fannie and Freddie. Their cost of funds would become cheaper than those of smaller competitors, and the incentive could be for more and more institutions to get bigger to rate the "systemic" brand of too big to fail.

This is the moral hazard that Paul Volcker mentioned in recent remarks that we excerpted Tuesday but that goes unaddressed in the Obama plan. ...

The larger question is why all of this regulatory reshuffling needs to be done so quickly, when we are still too close to the mania and panic to have truly absorbed their policy implications. The political class wants to rush through something to claim it has solved the problem, even if it means creating new and different problems later.

From a speech by former Federal Reserve chairman Paul Volcker on June 11:

Another important common concern is the "too big to fail" syndrome -- the presumption that an institution is so large or so inter-connected with counterparties that its creditors (possibly even shareholders) must be protected. One unfortunate consequence of the massive public assistance provided both banks and nonbanks in dealing with the present crisis is that moral hazard may, I am afraid, become more deeply embedded.

“Too big to fail” created a moral hazard that got us into this mess. Doesn’t anyone remember Fannie Mae?

Of course, if we had perfectly honest and perfectly prescient executives and regulators, we wouldn’t need institutions, controls and laws. The perfectibility of humans or human systems is (most recently) a socialist delusion not supported by any evidence from 300+ generations of recorded human history.