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Moral Hazard is widely misunderstood
"The shareholders lost everything" does not nullify moral hazard
I’ve seen a lot of commentary, by public officials and pundits, that because shareholders lost everything in the Silicon Valley bank bailout, there is no problem of moral hazard. This is Baloney Sandwich.
Moral hazard in banking is the incentive of owners to take large gambles with depositors’ money. That incentive exists even if the owners lose everything in a bailout.
Suppose that my bank is no longer profitable. Perhaps some loans I made in the past went sour. Or maybe my costs are high because I am a bad manager.
At this point, if I obtain some more funds from depositors , I can go to Las Vegas and hope I get lucky. If I lose, I have not lost anything, because my bank was not profitable. If I win, I can get rich. In fact, I will be desperate enough to try this that I will pay an above-market rate to get deposits. And depositors will be content, knowing that the government is providing a guarantee.
Note that in the process of bidding for deposits, my unprofitable bank pulls money away from profitable banks, who would rather not pay above-market rates. That is another adverse effect of moral hazard that no one seem to understand.
Regulators exacerbate moral hazard by a policy of “extend and pretend.” Joseph Politano writes,
The Federal Reserve would make additional funding available to banks through the Bank Term Funding Program (BTFP), offering loans of up to one year to depository institutions that pledged any collateral eligible for open-market operations. Critically, that collateral will be valued at par instead of at fair value, meaning that banks with large unrealized losses on high-quality held-to-maturity assets thanks to rising interest rates will be able to borrow from the BTFP as if those assets had not lost value.
I want to scream “No!” That is exactly what the Federal Home Loan Bank Board did during the tail end of the S&L crisis. It made the losses much worse.
Suppose that my bank is under water, but you let me pretend that it isn’t by lending me money as if my assets are still worth what I paid for them. What am I going to do? I am going to take your loan and go to Las Vegas. If I win, yes, things will work out fine for me and for the taxpayers. But if I lose, then the taxpayers will have to cover even more losses. That is what happened in the 1980s. Go back and read Mark to Market Sooner, Not Later.
I apologize for putting up two posts in the same day. I apologize for talking about the Current Thing, which I try not to do.
But I am an old man, who remembers how past crises were bungled by authorities who were blind to the moral hazard problem. And it is painful to watch it happening again.
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