Misunderstanding Moral Hazard

Misunderstanding Moral Hazard

Strategies to deal with the risk caused by moral hazard in the financial sector have been at the center of regulatory reform since the 2008 financial crisis. But some maintain that changes in financial regulation since ‘08 have increased moral hazard in the financial system.

In a recent post titled “Do liquidity regulations reduce moral hazard?”, Bank Policy Institute Executive Director Bill Nelson argues that the costs of liquidity requirements might outweigh the benefits since they don’t solve the moral hazard problem. While moral hazard stemming from federal guarantees is a real concern, Nelson admits, these regulations add their own set of moral hazards:

While the concerns about the moral hazard cost of central bank lending are real, those concerns apply equally to using liquidity requirements to address bank liquidity problems. If a bank sells its [high quality liquid assets] to pay off uninsured short-term creditors, the consequences are the same as when it pledges assets to the central bank and borrows from the central bank to pay off uninsured short-term creditors.  The risk of loss is increased for the remaining creditors and the deposit insurance fund, and the pool of creditors available to absorb loss is decreased. Short-term creditors, knowing a bank is subject to the LCR, will know that they will be repaid and have no incentive to price for or monitor the risk of the bank. [Emphasis added]

Leaving aside the question of whether or not the process of selling assets to pay creditors is the same as relying on the Fed to make payments is, in fact, “the same,” it is the bolded point above that I take issue with.

Yes, minimum liquidity requirements can make creditors feel more certain that they will be repaid, much like having a central bank with the ability to lend freely in a crisis. But Nelson’s argument muddies the water on why minimum capital and liquidity requirements are important.

Imagine the debate were on food safety regulation. We can then rewrite Nelson’s argument as, “consumers, knowing a butcher is subject to the FDA, will know there is a limited amount of rat feces in their meat and have no incentive to price for or monitor the risk of the butcher.”

Do minimum safety standards, either for food or banks, provide a certain ease of mind for consumers and creditors? Yes, but this is less a question of moral hazard and more a question of consistency in the marketplace, which is a far cry from government-backed bailouts. By shifting the ability to pay creditors from the central bank to the private sector, we can provide the certainty needed for the market to function efficiently without relying on ad hoc, potentially cronyist support from the government.

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By |2019-04-25T08:23:56-07:00April 25th, 2019|Blog, Financial Regulation|