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.

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