Banking crises have far reaching effects on the entire economy and in the past two decades, the frequency of these crises has increased. Banks have throughout history engaged in the business of money-lending. This business is said to pose a moral hazard to society through the inherent dangers of debt. The issue of moral hazard has come under the spotlight in the past few years following the financial crisis that have been experienced. The risk of moral hazard arises when a banking institute takes on an unmanageable level of risk in light of the fact that the central bank will intervene and bail out the institute should failure occur. The readiness of the central bank to support the facility is assured since the institute failure is presumed to adversely affect the stability of other institutions or even the confidence of the entire financial markets. The Article “Moral Hazard on Steroids” by Cooley Thomas aims to address the dangers that come about from protecting people or firms against risk. The article asserts that moral hazard is being heightened by the willingness of the government to bail out failing firms.
Cooley begins his article by reminding us of the warning to be wary of Moral Hazard fundamentalists issued by an optimistic Summers Larry. This warning assumed that central banks could be trusted to make prudent judgments during financial crises. These judgments would be made by considering the contagion effects and ensuring that the actions do not impose costs on taxpayers. However, this optimistic perception was wrong since central banks engage in public action even when it imposes costs on taxpayers. This is because while regulatory policies are effective in responding to financial crisis that occur, they do not always respond in the most astute manner
The article highlights the principle behind moral hazard as protecting people or firms against risks. However, this protection invariably results in the encouraging of more risk taking. While government policy interventions are designed to stabilize the financial market and avoid crisis in the financial system, the policies seem to create more crisis in recent years. The promise of government bail out has resulted in financial lenders practicing little to no prudence as they seek to make economic returns that are of greater value than the input. This behavior invariably imposes costs upon the tax payers who have to bear the risk and monetary cost that comes from failure. Cooley proposes that firms which gamble should be made to suffer the consequences of their actions. As it is, banks are in the habit of choosing a risky asset portfolio that promises high profits should the gamble succeed. However, if the gamble fails it is the depositors of their insurers who are made to face the losses.
While the failure of Lehman Brothers should have provided a chance for changes in how the government deals with the moral hazard issue, the author fears that policy makers may have taken the wrong lesson from the disaster. While the disaster should have led to restructuring of important firms to avoid such future failures, it led to more bailouts and guarantees being promised. The author notes that while government intervention was necessary, it had the negative effect of precipitating the next crisis. If banks are obligated to hold sufficient capital, they will be able to internalize any losses that can come about from gambling and this will undoubtedly result in more prudent investments being made by the bank. This is a fact since capital requirements reduce the incentive for banks to gamble by putting bank equity at risk.
Financial firms have insurance programs in place which are supposed to provide financial support. In times of financial crisis, the Federal Reserve acts as a lender of last resort and the insurance it provides is borne by the tax payer. The article notes that whole this role of last resort lender has been existence for decades; the penalty rate that was traditionally imposed is no longer there. In addition, the Federal Reserve now offers its services to an even more expanded list of firms. The government policy for bailing out banks is well-meaning but misguided since it is paving the way for more failures. Instead of extending its lending services, the Federal Reserve should exercise restraint. The role of government as the deposit insurer should be based on the level of capital that the firm holds and on whether the bank has gambled or investing prudently.
The article also questions the wisdom behind labeling some firms as too big to fail and therefore the government is obligated to do whatever is necessary to keep banks in business. Such a notion provides guarantees to the institutes and this guarantee is footed by the taxpayer. This policy of intervening with financial support if institutes that are considered “too big to fail” exacerbates the issue of moral hazard. This is because such firms have little incentive to exhibit caution or prudence in their operation since they are not at a risk of losses. Such institutes can engage in harmful practices such as overvaluing loans. This practice is detrimental since sound financial practices dictate that a firm should reduce the value of loans that are likely to be defaulted. In addition to this, the firm is required to alert the market of this high risk. Withholding of information from relevant parties results in damages and was one of the courses of the 2008 financial meltdown.
Markets are competitive to such a level that gambling of some form must occur in the free market. Banks are inclined to lend so as to receive interest on their loans. Bank failures are traceable to a decline in the value of bank loans which comes about from diminished financial capabilities by the borrowers. However, some form of prudential regulation must be employed by the banks when vetting their potential debtors. A common consensus among economists is that banks should have sufficient capital at hand. Requiring sufficient capital is a sound practice since it is a reasonable assumption that al businesses should make profits that are within the limits of the amount of investment made by the business owners. The logic behind capital requirements is that if a firm invests in its own capital, then the capital acts as a bond and the bank stands to bear the brunt from losses that may arise from risky assets.
Cooley restates that the policies in place today reinforce the belief that some firms are too big to fail which has led to guarantee programs funded by the Federal Reserve to ensure the success of such firms. As a result of the guarantee of bailout, the practice of under pricing insurance has taken place. This habit has resulted in Insurance firms being unprepared for a financial crisis. The deposit insurance regime can therefore be viewed as a destabilizing element in the banking system.
The article concludes by reiterating that risks by firms are continually being shifted to the taxpayer instead of having the firms which engage in the risk bear the cost of their mistakes. This practice is slowly moving the country towards even bigger crisis in future. For example, it is a plausible assumption that the generous government subsidization of subprime mortgage risk taking as well as the sponsored deposit insurance contributed to the recent financial crisis. A more prudent approach would be for the government to create an environment where firms are forced to consider the risks before making investments. Such an environment can only be created if the firms know that they will have to pay for the losses that may result from high risk investments made.
Banking crises are important since they affect the entire economy of a nation and have huge consequences for everyone. This paper set out to review the article “Moral Hazard on Steroids” by Cooley Thomas. Through this paper, it has been demonstrated that while banks are an absolute necessity for the national and international economy, the bail outs they are guaranteed and given when they fail only leads to the likelihood of more failure in future. This cost of this failure is borne by the taxpayer while the firms continue with their business. Making banks internalize the cost of gambling should be the favored policy by the government.
Cooley, Thomas. Moral Hazard on Steroids. 2009. Web.