Category / Moral Hazard

Break them up March 24, 2012 at 8:18 am

From the final paragraph of a wonderful essay by Harvey Rosenblum, Dallas Fed executive vice president and director of research:

The road to prosperity requires recapitalizing the fnancial system as quickly as possible. The safer the individual banks, the safer the fnancial system. Te ultimate destination—an economy relatively free from financial crises—won’t be reached until we have the fortitude to break up the giant banks.

Go read it.

Good grief January 20, 2009 at 5:20 am

This is something I never thought I would read in the Economist:

Why not nationalise?

And I agree. For those banks that have lost the confidence of the market – like RBS – the best way to protect the economy while minimising costs for the taxpayer (and moral hazard) is nationalisation. We have a historic opportunity to reshape the banking system. Let’s take it.

Bad banks January 19, 2009 at 12:52 pm

Not bad as in `bad girl’. Bad as in non-performing. Paul Krugman makes the point that bad banks are not the answer to banking system problem, they are a tool for recovering more for the taxpayer after the banks have been nationalised, cleaned up, and sold on. In other words, wiping out existing shareholders is the first step. Let’s begin with RBS shall we?

Update. Interfluidity has a nice post on full nationalisation and the Swedish model. The importance of excluding shareholders from future participation is clearly made:

Suppose that a bank whose true book equity is $0 has failed to mark down some assets, and shows a position of $10B. The bank receives a $90B capital injection, valuing existing shares at book. Then the old equity whose true value was precisely zero prior to the recapitalization suddenly has a real book value of $9B. That is, old shareholders reap an immediate windfall from the recapitalization, and the size of the windfall increases in direct proportion with the amount to which management had lied about the banks losses!

Arguments against the conservation of cake December 5, 2008 at 9:53 am

Or, why you can’t have it and eat it. Information Arbitrage is wonderfully splenetic about bailouts:

The U.S. taxpayers saved Citigroup’s life, and for that we may get up to 8% of the company. THAT is called a “punitive program” in Hank’s parlance – punitive for the U.S. taxpayer. In my world when you save a company you own ALL the equity, not 1/12th of the equity. The fact that the taxpayer gets up to 80% of AIG – now that starts to make sense.

Quite right. To do anything else involves moral hazard. By all means bail out a systemically important player if you judge it necessary. But be sure to crush the equity holder.

Keeping the party orderly July 22, 2008 at 8:51 am

A post on VoxEU discusses the debate between Larry Summers style ‘the FED must drop money on Wall Street until the problems end’ interventionists and the moral (and I believe broadly correct) position that banks ought to be left hanging to pay for their sins. Governments ought to be worried about their taxpayers, not bank shareholders. VoxEU calls this the Willem Buiter position, which is not entirely accurate (Buiter’s position is more nuanced) — but let’s run with it.

The argument is that the moral hazard in permitting a Summers style bail-out is too great to permitted:

once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

…Bank of England Governor Mervyn King nicely sums up the situation: “’If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder.”

This would be true without regulatory capital. But if it works as intended regulatory capital should stop the party from getting too rowdy. The current crisis came about because capital requirements were not effective in constraining banks’ risk. The solution for now is a rescue with shareholder expropriation where necessary for the protection of depositors and the financial system. The solution for the future is getting regulatory capital requirements right. And minor changes to Basel 2 won’t do that.

Calculated Bunk July 11, 2008 at 6:34 pm

Calculated Risk has a post on Fannie and Freddie that defies belief. Commenting on the suggestion that the US government should bail out the agencies without screwing the stock holders – for instance by buying new sub debt to provide liquidity – they say:

If this blog’s comment threads are any kind of representation of a slice of reality–I am often agnostic on that question, but still–there are more than a few people who are more interested in getting a front-row ticket to a morality play than working through a financial crisis with the least (further) damage to the banking system. Lord knows that a lot of bad policy can be floated along under the guise of “pragmatism,” but I for one would rather try debating with a pragmatist than a purist or a moralist.

Two words Tanta – moral hazard. It is vital that any government support of the agencies is at the cost of the equity owners. To do anything else isn’t pragmatism, it is the grossest and least defensible public subsidy of the providers of risk capital. By all means let the US government support the Agencies if it judges that to be in the national interest. But do it in such a way that those who were perfectly happy with the rewards of Fannie and Freddie’s absurdly high leverage also bear the consequences of it. Capitalism is a broad church but it does not include privatised gain and socialised loss.

Spire

Buyers vs. Financers April 15, 2008 at 6:35 pm

There has been some discussion recently of the central banks buying assets such as RMBS rather than simply providing financing for them. Intuitively I am less enamoured of this idea. Some of these assets may indeed represent a screaming buy at current levels, but I find it hard to believe any government body would have the expertise to assess that. Moreover many of the sellers are reluctant to trade at the current level, and the moral hazard of buying above the market is evident and insupportable. Perhaps instead the central banks could provide a financing wrapper to encourage liquidity in the market. Much like a bond wrap is a guarantee that if the bond does not pay then the wrapper will, so a certificate of finance would allow the holder of the bond whoever they may be to access the central bank window to finance the asset (with an appropriate haircut). The certificate would be specific to the asset so the central bank could target the financing appropriately, and it could have a reasonable but not excessive life – a year, perhaps.

Update. If the Bank is going to offer 2 way repos, ABS vs. gilts, then just make these repos assignable so the bank can sell the ABS with the repo in place. Job done.

Avoiding moral hazard, scandanavian style April 1, 2008 at 8:32 am

Apparently Ikea has started to offer a new product using classic Scandi design, BankiRescu. The FED has been taking a few trips over to Elizabeth New Jersey to stock up. From the Telegraph:

A senior official at one of the Scandinavian central banks told The Daily Telegraph that Fed strategists had stepped up contacts to learn how Norway, Sweden and Finland managed their traumatic crisis from 1991 to 1993, which brought the region’s economy to its knees.

It is understood that Fed vice-chairman Don Kohn remains very concerned by the depth of the US crisis and is eyeing the Nordic approach for contingency options.

If this is true, it is encouraging. Even if you don’t follow historical precedents, understanding them is important.

[…] there was a major effort [in the Scandi rescue] to avoid the sort of “moral hazard” that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.

To be fair, I would say more the Bank than the FED. For shareholders to get something if the bank is solvent at the time of rescue does not seem unreasonable, after the public purse has been reimbursed for the cost of funding the bank through the rescue. For them to get the share price at the point of rescue, or more, as may well happen in the case of Northern Rock, is pure moral hazard.

Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country’s top four banks – Christiania Bank and Fokus – were seized by force majeure.

“We were determined not to get caught in the game we’ve seen with Bear Stearns where shareholders make money out of the rescue,” said one Norwegian adviser.

“The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial,” he said.

Stefan Ingves, governor of Sweden’s Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against blackmail by shareholders.

Why 2% I wonder? Why not 8%? After all, if you view regulatory capital as providing a buffer for an orderly liquidation/takeover/whatever, once that buffer is breached, the bank’s shareholders and management should lose control. In any case, the idea that bank stock is a fundamentally different thing from the stock of other companies, with a different insolvency regime, makes a lot of sense. That regime is triggered by capital inadequacy or liquidity problems, and at that point the management are out and the shareholder only gets something after the costs of the rescue are met.

Mitigating Moral Hazard February 21, 2008 at 11:16 pm

Willem Buiter has a typically intelligent post on Northern Rock. He ends, as one might expect, with a discussion of moral hazard:

Future Northern Rocks will be encouraged to fund themselves recklessly and to lend and invest recklessly. Their creditors are after all the beneficiaries of a free government guarantee. If their bets come off, management, super-employees shareholders and creditors benefit. If they fail, the shareholders may still lose (I hope), but taxpayer picks up the tab for the rest.

At first sight, this seems reasonable. But there are things that can be done to mitigate this moral hazard.

  • We need a new insolvency regime for banks, which allows regulators to intervene at an early stage [and obviously includes intervention due to liquidity as well as solvency]. It should ensure that equity holders only get something once everyone else, including the lender of last resort, has been paid back at market rates. This mitigates moral hazard for equity holders as they do not benefit from the rescue. In order to get this right we may need to reduce some of the statutory rights of equity holders, so perhaps we will end up with a new instrument, bank stock, which grants the holder less control than ordinary equity.
  • Revisions to compensation practices should ensure that employees, particularly senior employees, are paid in shares that lock up for an extended period. This combined with the above encourages employees to avoid the need for a rescue.
  • Enforced liquidity ratios are needed to limit the amount of debt the bank has compared with deposit funding. That means that although debt holders benefit from government intervention, there at least aren’t too many of them. Obviously this regime should apply to off balance sheet liabilities too, including derivatives contracts in the trading book.
  • There is little moral hazard with retail depos as most of them are government guaranteed anyway. We could force banks to buy insurance against interbank and commercial deposits too if need be.

I am not necessarily suggesting all of the above is a good idea. But it does make it clear that moral hazard can be mitigated if you are willing to make enough changes.