Equity With and Without Safety Nets

Equity With and Without Safety Nets

In their chapter on financial regulation in The Captured Economy, Brink Lindsey and Steven Teles argue that the moral hazard in our financial system created through a series of formal (such as FDIC deposit insurance) and informal (namely the promise of TARP-style bailouts) safety nets for financial institutions fuel excessive leverage and low equity financing in the financial system.

While they do not point to any one form of moral hazard as the cause of this state of affairs, their “argument is focused, not on specific policies and how they work in isolation, but rather on the whole underlying regulatory model.”

Writing for the New Zealand-based Croaking Cassandra, Michael Reddell uses the piecemeal approach Lindsey and Teles argue against when viewing the financial sector to determine what the influence of deposit insurance is on bank risk-taking in the form of how much they finance their investments with equity:

[T]here is a striking similarity in the capital ratios across [both large and small New Zealand] banks (and a striking similarity in the margins above minimum regulatory requirements). It doesn’t appear that consistent with a story in which the big banks are now able to get away with artificially low levels of capital because of the actual or implied bailout and guarantee risks.  And that is especially so when one recognises that none of the four small local banks has a deep-pocketed parent who might be prevailed on to recapitalise the bank if it got into trouble.

While I cannot speak to the intricacies of New Zealand’s financial sector and regulations, his methods take a forest-for-the-trees approach to examining moral hazard. Deposit insurance is one part of the financial safety net, and it’s Reddell’s skepticism of the tacit promise of a bailout that I find objectionable.

Research shows that governments cannot credibly promise to not bail out distressed financial institutions, especially during times of crisis, and it is is this particular form of moral hazard that has a greater influence on bank risk-taking and financial stability than traditional deposit insurance. Other research shows that in the U.S., bank valuation incorporates both a franchise value and the value of government guarantees.

Perhaps New Zealand is the exception, but either way Reddell’s argument is far from a conclusive argument against higher capital requirements more broadly.

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By |2019-02-11T09:34:55-08:00February 11th, 2019|Blog, Financial Regulation|