The government’s decision to bail out Citigroup during the financial crisis was made in a “strikingly ad hoc” manner—based on “gut instinct and fear of the unknown” and not on any objective criteria, according to a government watchdog report [PDF] released Thursday.

While the 2008 bailout of Citi served to immediately stabilize the company and strengthen it long term, the bank remains “an institution that is too big, too interconnected, and too essential to the global financial system to be allowed to fail,” the report by the Special Inspector General to the TARP said.

In all, the government handed over $45 billion to shore up Citigroup during the financial crisis. The Treasury recouped its investment last month, earning a total profit of more than $12 billion. (See our Citigroup bailout page for the details.)

But despite the seeming success of its Citi bailout, the report concludes that the government’s actions created a moral hazard and further increased the existing market advantage of big financial institutions by serving as a backstop for risky behavior. From the report:

When the Government assured the world in 2008 that it would not let Citigroup fail, it did more than reassure troubled markets – it encouraged high-risk behavior by insulating risk takers from the consequences of failure.

Unless and until institutions like Citigroup can be left to suffer the full consequences of their own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results.

The report’s findings were echoed over the weekend by a post on Washington’s Blog, a financial blog, which argued that the government’s failure to break up the big banks will hamper economic recovery and continue to encourage risk. The post pointed to a number of independent economists and financial experts who have spoken similarly.

The Dodd-Frank financial reform bill passed last year aimed to end bailouts of large banks by giving the FDIC a framework for winding down “systemically significant” financial firms. Despite these new powers, the report notes that Treasury Secretary Timothy Geithner told the report's authors that future shocks to the financial system could mean having “to do exceptional things again.”

A Citigroup spokeswoman told Bloomberg that Citi “is a fundamentally different company today.” “We have bolstered our financial strength, overhauled our risk management, reduced our risk exposures, defined a clear strategy and made Citi a more focused enterprise by returning to banking as the core of our business,” she said.