Federal Deposit Insurance Corp. Chairman Sheila Bair said past regulatory policies helped encourage arbitrage by institutions, which in turn contributed to the recent crisis.

Bair, speaking Monday to a business economists' group, said reforms enacted after the thrift crisis of the 1980s led to safer practices in the banking industry, including higher capital levels. But those reforms erred, she said, by excluding nonbanks and creating "incentives for financial services to grow outside of the regulated sector, in the so-called shadow banking system."

"The irony is this: The very measures put in place after the last crisis to limit moral hazard in banking helped to push risk-taking outside traditional banking into the shadow banking system," Bair said in remarks to the National Association for Business Economics. "There, on the periphery of our banking system, where there were gaps between regulatory jurisdictions and inadequate protections for consumers, the risks grew unchecked."

Bair said lawmakers debating an overhaul of financial regulation need to make sure reforms capture all the important players, not just banks.

"Markets remain the best mechanism for making decisions that involve risk — but only if they operate under an institutional structure that requires all firms to bear the downside consequences of the risks they take," she said.

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