Commercial Banks, River Banks, and Moral Hazard

Quite a few economists are worried about moral hazard in financial markets. Vince Reinhart wrote a Wall Street Journal column rebuking his former bosses after the Bear Stearns intervention: “…the Federal Reserve’s action can only be viewed as rewarding bad behavior.” Ken Rogoff recently wrote in a Financial Times column, “it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?”

Of course moral hazard is a serious problem that lies close to the heart of the financial market crises. But I am not sure that I completely share the priority at this point on drawing a tougher line with the ex post bailouts. It may be futile advice. Fixing the hole in the roof when it is raining is, after all, rather difficult.

Consider two other areas where moral hazard is an issue: commercial banks and river banks. Some economists would prefer that the government refrain from helping the victims of banking panics and river floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future.

But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates mandatory federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for a wider range of financial institutions.

As a final tweak, I can’t help noting that central bank governors, Treasury secretaries, and chief executives who make the most noise about the evils of moral hazard and bailouts ex ante, are no more likely to stand firm ex post than others. If anything, the reverse. I am thinking, for example, of how – ten years ago this month – it was the Clinton Administration that finally pulled the plug on continued IMF loans to Russia, despite well-founded fears of systemic contagion. The Reagan Administration in the 1982-84 international debt crisis and the Bush Administration in the 2001-03 Argentine crisis, for all their laissez-faire rhetoric, never pulled the plug on any of the debtor countries. When sitting in the hotseat of a financial crisis, officials suddenly discover a need for bailouts, much like soldiers sitting under fire in foxholes sometimes suddenly discover a need for religion.

Originally published at Jeffrey Frankel’s Weblog and reproduced here with the author’s permission.

One Response to "Commercial Banks, River Banks, and Moral Hazard"

  1. PhilT   August 13, 2008 at 9:52 pm

    Moral Hazard is only relevant when the situation at hand involves moral actors. Moral Hazard is not only irrelevant, but illogical in an immoral or amoral environment with immoral/amoral actors.The are very good reasons that the Bear Stearns /JPM’s of the world should have been handled much differently, having zero to do with Moral Hazard.Sincerely,