Airs – Ian Lance Taylor

Moral Hazard

The U.S. government is trying to free up credit, by reducing interest rates and other steps. This is probably good for the economy. It also has the effect of reducing the risks faced by banks which made some very bad investment decisions in purchasing unsecured debt. This is a moral hazard: when things go well, the banks keep the money; when things go badly, the government cushions the blow. The effect is to encourage risky behaviour by banks.

We can avoid a lot of this moral hazard by realizing that banks are run by individual people. We can bail out the bank and punish the people, thus getting the best of both worlds and not encouraging future risky behaviour. Certainly it’s true that some bank CEOs have lost their jobs recently, but they walked away with millions of dollars, which is hardly punishment. I don’t think any of them committed a prison offense, but I certainly think some stiff fines coupled with losing their job would be appropriate–whatever it takes so that they are not rich.

Unfortunately this will never happen because the people who make the regulations are also individual people, and they are friends of the people who run the banks.

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Ian Lance Taylor

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5 responses to “Moral Hazard”

  1. fche Avatar
    fche

    > The effect is to encourage risky behaviour by banks.

    That effect must be even more unintended than the encouragement of risky behaviour by uncreditworthy consumers, who after all purchased these credit/property products.

  2. Ian Lance Taylor Avatar
    Ian Lance Taylor

    There is no moral hazard for the consumers: the ones who can’t pay the bills are losing their homes. The moral hazard here is for the banks, which are not paying a similar penalty for their equally poor judgement.

    (Again, it’s not necessarily a bad idea to bail out the banks, but it should ideally be done in a way which discourages them from acting this way in the future. So far that is not happening.)

  3. fche Avatar
    fche

    > There is no moral hazard for the consumers: the ones who can’t pay the bills are losing their homes.

    Really? All the recent bailout noises from Washington were about letting (some of?) these troubled (“can’t pay”) homeowners keep their homes. (The Federal Reserve is doing stuff to help banks, but that’s a separate matter.)

  4. rskrishnan Avatar
    rskrishnan

    For what it’s worth …

    Washington tends to bail out the banks first, the homeowners second – after all the financial sector has among the biggest lobbys. The noises of bailouts to homeowners tend to remain noisy, with very little real signal in them. Talks about an interest rate freeze are just words, and with the worst yet to come (in 3-4 years when the rest of the iceberg comes up).

    Any concrete piece of news you see/hear is about Bank xxx being bailed out by some “pooled fund”.

    And it’s not just the USA … UK just bailed out one of their banks by “nationalizing” it. It might be a prudent move but I suspect there was a bit of “Oh Mommy it’s raining, and my feet got wet” as well!

    I would vote for a bank bail out with some punitive elements thrown in to discourage future speculation. Right now there is no downside to reckless investment for the banks, and they keep any upside that shows up. The fall in stock prices don’t actually affect the bank, or it’s ceo/coo/cfo/investment policies – since the stock price is reaction to a fait accompli of sorts – the deal is already done.

    Ah well … maybe I should run out and start a bank for geeks!

  5. Ian Lance Taylor Avatar
    Ian Lance Taylor

    rskrishnan: thanks for the note.

    fche: what rskrishnan said.

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