Moral hazard: The case to increase regulation

This piece from Vox Eu provides a good run down of one of the issues of that exists when we have a central bank as a lender of last resort – moral hazard.

The prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner.

As long as we need a lender of last resort to prevent against bank runs – we also need to lean against the moral hazard implicit in any of this sort of support.

The question I have is, how do we then try to make banks price in the full social risk of their actions, when they are protected in the “worst case scenario”.  In essence this suggests there is some “externality” and so we will want to have some type of “externality tax” for these banks.

However, this is an issue we need to look into, I see the argument as follows:

  1. We require a lender of last resort function for central banks, to prevent bank runs on solvent banks facing liquidity issues.
  2. However, this function creates a moral hazard problem – because some of the downside risk is socialised
  3. Given that, how can we solve the moral hazard issue?

This is one of those cases where the initial issue (bank runs) is serious enough that it seems worth dealing with the unintended consequences directly – instead of dumping the policy of a “lender of last resort” completely 😉

3 replies
  1. Miguel Sanchez
    Miguel Sanchez says:

    Bagehot gave us the solution over a hundred years ago – lend freely at penalty interest rates. The reason we have a moral hazard problem is because central banks have built up a track record of doing the opposite, i.e. lending at below-market rates, and/or trying to lower market rates themselves, at the first whiff of liquidity problems.

  2. raf
    raf says:

    We could change the way banks are structured.

    1) They could be strictly savings and loans institutions i.e. lending out what they take in.

    2) We could shift from a debt system to an equity one.

    3) We could have 100% reserves.

    The current fractional reserve system encourages risky behaviours from banks and deposit guarantees simply add to that. Banks have had a taxpayer subsidy for 323 years and it’s about time we reclaimed some of that back. 

    The purpose of a central bank should be to create money and manage its supply so as to keep its value stable.

    People can use banks for storing this money or as lending vehicles for investing it.

    Current system is kaput. 


  3. Miguel Sanchez
    Miguel Sanchez says:

    Hmmm. I would make the case that it’s governments that have been subsidised for 323 years, by savers.  Having a central bank gives you the option of monetising the national debt.  And even before then, rulers found other ways of ‘subsidising’ themselves, e.g. Edward IV allowing the Medici bank to provide trade finance in England as long as they lent him as much as he wanted, with no real hope of repayment.  

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