Moral hazard in banking

Overview

How deposit insurance creates moral hazard, existence of a lender of last resort create moral hazard and too big to fail.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does the expectation of a government rescue change how a large bank behaves?

   Model answer

   A bank that believes it will be supported if it fails does not bear the full cost of its own risk-taking, so it will lend more aggressively, hold thinner capital and take positions it would avoid if the losses fell on it alone. The gains stay private while the losses are shared with the taxpayer, which is why regulators impose capital and liquidity requirements rather than relying on the bank's own judgement.

2. 2

   Distinguish moral hazard from adverse selection.

   Model answer

   Both arise from asymmetric information, but at different points in the relationship. Adverse selection occurs before the contract: the party with better information about its own type chooses whether to enter, so the pool that accepts a given price is disproportionately made up of the worst risks, which is why the sickest people are keenest to buy health insurance and the shakiest borrowers are keenest to accept a high interest rate. Moral hazard occurs after the contract: the terms are already fixed, and the informed party now changes its behaviour because it no longer bears the full cost of its actions. Screening and signalling address adverse selection; monitoring, excesses, deductibles and requiring the informed party to retain some of the risk address moral hazard.

3. 3

   Explain how deposit insurance creates moral hazard, and evaluate whether it is nonetheless worth having.

   Model answer

   If deposits are guaranteed, depositors have no reason to investigate whether their bank is prudently run, and will place funds with whichever bank offers the highest rate. That removes the market discipline that would otherwise force risky banks to pay a premium or lose funding, so a bank can finance risky lending cheaply and shift the downside onto the insurance scheme and ultimately the taxpayer. It is nevertheless worth having, because without it ordinary depositors, who cannot assess a bank's balance sheet, will withdraw at the first rumour, and a run can destroy a solvent bank and spread to others. The usual response is to keep the guarantee, since the stability benefit is large, and to offset the incentive problem by regulating what insured banks may do, requiring them to hold capital, and charging premiums related to risk.

4. 4

   Why does the existence of a lender of last resort create moral hazard, and how can the problem be limited?

   Model answer

   A bank that knows the central bank will lend to it in a liquidity crisis can hold fewer liquid assets and rely more on short-term funding than it would if it had to survive unaided, because the cost of a funding squeeze has been shifted to the central bank. That raises the profitability of a fragile balance sheet and makes crises more likely. The classic limits are to lend only against good collateral, so an insolvent bank cannot obtain support; to lend at a penalty rate, so the facility is unattractive except in genuine distress; and to combine the facility with liquidity requirements that oblige banks to hold a buffer of saleable assets in the first place. Some authorities also maintain deliberate ambiguity about whether and how they would act, so that no bank can plan on being rescued.

5. 5

   What is meant by too big to fail, and why is it a moral hazard problem?

   Model answer

   A bank is too big to fail when its collapse would do so much damage to the payments system, to other institutions and to the wider economy that the authorities cannot credibly allow it to happen. Everyone concerned understands this, so the bank's creditors expect to be repaid whatever it does, and they therefore lend to it more cheaply than to a smaller competitor of the same riskiness. That funding advantage is effectively a subsidy, and it rewards precisely the strategies that make failure catastrophic: growing larger, becoming more interconnected and taking more risk. The bank's own managers and shareholders keep the upside of risky lending while the downside falls on the state, which is moral hazard in its purest form, and it also distorts competition against smaller banks that enjoy no such guarantee.

6. 6

   Analyse how limited liability contributes to excessive risk-taking by banks.

   Model answer

   Shareholders of a limited company can lose no more than the capital they have subscribed, but they receive the whole of any profit above what is owed to creditors. That gives their claim the shape of an option: as leverage rises and the equity cushion thins, a risky strategy offers them a large gain if it succeeds and a loss capped at an amount that is already small. The rational shareholder therefore prefers more risk than a creditor or a taxpayer would choose, and the preference is strongest exactly when the bank is weakest, which is when it is most dangerous. This is the fundamental reason regulators impose minimum capital requirements rather than leaving leverage to the market: forcing shareholders to keep more of their own money at stake realigns their incentives with those of everyone else.

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