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The public sector subsidises this risk-taking. It does so because banks provide a utility.
What the banks give in return, however, is gung-ho speculation.
Martin Wolf, FT November 27 2007

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks.

Perhaps the most striking characteristic of the banking sector is its profitability

As Andrew Smithers of London-based Smithers & Co and Geoffrey Wood of the Cass Business School at the City University London note in a splendid report, from which I have taken these data, long-run real returns on equity in the US have been a little below 7 per cent.

A starting assumption for a competitive economy is that returns on equity should be much the same across industries... Yet banks are also thinly capitalised: the core “tier 1” capital of big UK banks is a mere 4 per cent of liabilities. If returns on equity become negative in a thinly capitalised business, many banks will become insolvent.

How do banks get away with holding so little capital that they make the most debt-laden of private equity deals in other industries look well-capitalised? It can hardly be because they are intrinsically safe. The volatility of earnings, the history of failure and the strong government regulation all suggest that this is not the case.

The chief answer to the question is that banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the UK Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders’ funds in institutions deemed too big or too politically sensitive to fail.

Full text

Why Do Financial Firms Take Too Much Risk?
The principal/agent problem
John H. Makin, American Enterprise Institute, November 20, 2007