"Commercial Banks, River Banks, and Moral Hazard"

Jeff Frankel:

Commercial Banks, River Banks, and Moral Hazard, Jeff Frankel: Quite a few economists are worried about moral hazard in financial markets. ...

Of course moral hazard is a serious problem that lies close to the heart of the financial market crises. But I am not sure that I completely share the priority at this point on drawing a tougher line with the ex post bailouts. It may be futile advice. Fixing the hole in the roof when it is raining is, after all, rather difficult.

Consider two other areas where moral hazard is an issue: commercial banks and river banks. Some economists would prefer that the government refrain from helping the victims of banking panics and river floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future.

But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates mandatory federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for a wider range of financial institutions. ...

Beyond helping flooded out homeowners, as with Bear Stearns, if there was ever a natural disaster costly enough to threaten the health of the insurance industry and the financial system more generally, I suspect the government would step in with a bailout for insurance companies. We can argue that the insurance companies never should have written such risky policies, but having a dysfunctional insurance industry would be stifling.

Some risks are too large for the private sector to carry on its own, when very large shocks hit the private sector may not be able to fully absorb them, and we rely upon and expect government to step in when shocks are so large that they endanger the overall economy. The government can and should act as insurer of last resort when the health of the economy is threatened, it really has no choice, and because of that regulation will be needed to, as much as possible, limit the the chance that the impact from a shock will require the government to intervene.

Comments

[Bruce Wilder]

Angelo Mozillo will be a hero to someone. Oh, well, I guess.

[ken melvin]

This moral hazard, if it really worked we'd need naught else, now would we?

[Bruce Wilder]

To be more explicit, if we could haul God into court for flooding the Mississippi to goose church attendance, would we?

[Ryan]

If there were ever such a disaster as to jeopardize the entire insurance market, I'm not convinced that an insurance bailout would be the most cost efficient or sane solution. At that point, you might as well start employing massive rebuilding projects. Why go through an intermediary?

The same goes for the supposed banking bailouts. If we accept that the whole mess is a result of sub-prime debt holders unable to pay their mortgages, why are we providing access to cheap captial to the creditors/ Wouldn't it make more sense to open discount windows to the public?

[Stifford Runa]

If there were ever such a disaster as to jeopardize the entire insurance market, I'm not convinced that an insurance bailout would be the most cost efficient or sane solution. At that point, you might as well start employing massive rebuilding projects. Why go through an intermediary?

[Ryan]

Was that quoted for emphasis, or did you have a response in mind?

[Cyrille]

I am willing to accept a bailout if it is linked to a nationalisation.

Then the State should feel free to privatise later. But if you pick something up that had failed, do wipe out the shareholders (I'll throw in an exemption for the first X $ of pension funds, or other means-tested mitigation). And if the State get the business back to profitability, well it should get the rewards too!

[robertdfeinman]

I think the people of New Orleans would take exception to:

But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks).

Either Frankel hasn't been watching TV for the past few years, or he doesn't think we have a "democratic" government. I'll assume the latter.

As for some risks being too large for private firms - that seems to imply that firms should only provide insurance when they know that it won't be needed. Why should the government subsidize uneconomic activity? If the insurance firms only get to pick low risk, they why do we need them at all?

Flood insurance has been turned over the to government, homeowner's policies in Florida are being written by the state, nuclear power plants are insured by the government.

And then there is the whole issue of health insurance. One can have private firms which are guaranteed a fixed return, we used to have that with electric companies, and Germany has it with non-profit, regulated, health insurance companies.

What is seems people are asking for is that the financial sector be shielded from big risk as well. I think it is time to get away from this pseudo-capitalism. Fannie and Freddie worked fine as government entities. Perhaps we don't need private banks at all (or at least not for-profit ones).

We could go back to mutual savings banks, community banks and S&L's or their modern equivalents.

[jamzo]

when did moral hazard become a debate about the role of governemnt

i would argue that moral hazard does not apply to the victims of deceptive and predatory corporate strategies implemented by banks and financial corporations

i would argue that the current state of corporate governence is a moral hazard

from wikipedia

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

so far it seems as though the leaders of the financial industry who are responsible for the decisions on risk that led to current financial crisis are insulated from the conseguences of their decisions - they continue to get multimillon dollar compensation packages

these individuals and their institutions are not bearing the full consequences of their action

executives and boards in banking and finance are not unique in this respect

corporate boards and executives in most industrial sectors appear to have the same insulation

[foo]

The people who want to profit from the mess are the ones who keep bringing up this idea that "ordinary citizens" want to let banks fail in order to punish the wicked huddled masses in their blankets.

I don't think that's anywhere close to the truth. Most people are just fine with bailouts to preserve the integrity of the system (although we're going to grumble about the cost). What we're most certainly NOT fine with, is that the individuals who brought us this mess, and who profited in the hundreds of millions (think TanMan as the poster child here), are going to get off scot-free.

Or even worse, they're the ones who're getting the lion's share of the bailout money in their pockets.

Perhaps if the 'experts' took some time to see this distinction, they'd stop lecturing us about moral hazard and the importance of bailouts

[jamzo]

latest news from gm demosntrates how current state of corporate governance is a moral hazard

from the new york times

G.M.’s Directors Stand Behind Wagoner

By BILL VLASIC
Published: August 6, 2008
DETROIT — The chairman of General Motors, Rick Wagoner, has the “unified support” of the board and will continue to lead the troubled automaker, G.M.’s lead outside director said Wednesday.

After G.M. reported a $15.5 billion loss on Aug. 1, speculation had been growing on Wall Street and in the auto industry that Rick Wagoner might be in jeopardy of losing his job.

G.M. Board Gives Chief Some Time
(April 4, 2006)

George M.C. Fisher, who serves as presiding outside director of General Motors, said Rick Wagoner "has the unified support of the entire board to a person."

“Rick has the unified support of the entire board to a person,” said George M.C. Fisher, who serves as presiding outside director. “We are absolutely convinced we have the right team under Rick Wagoner’s leadership to get us through these difficult times and to a brighter future.”

G.M.’s 13 outside directors reaffirmed their support of Mr. Wagoner in a regular board meeting on Monday and Tuesday, Mr. Fisher said.

The meeting came after G.M. reported a $15.5 billion loss on Aug. 1, the third-largest quarterly loss in the company’s 100-year history.

Speculation had been growing on Wall Street and in the auto industry that Mr. Wagoner, who has been chief executive since 2000, might be in jeopardy of losing his job.

But in a rare interview, Mr. Fisher expressed nothing but support for Mr. Wagoner and his management team.

“In yesterday’s board session, there was unanimity in respect to our unequivocal support of Rick and our team,” Mr. Fisher said. “There has been a lot of rabble rousing in the media and it’s not true.”

Mr. Fisher, the retired chairman of Eastman Kodak, has been a G.M. director since 1996. As presiding director, he chairs executive sessions of non-management directors and serves as chief liaison between the outside board members and Mr. Wagoner.

While G.M. has lost more than $18 billion this year, Mr. Fisher said he saw no chance that the largest American automaker would seek bankruptcy protection.

“The answer is no, absolutely not,” he said. “We wouldn’t be doing our job if we allowed that to happen.”

Last month, Mr. Wagoner outlined a broad plan of cost cuts, asset sales and debt offerings to improve G.M.’s liquidity by $15 billion by next year.

The automaker has about $21 billion in cash on hand and another $5 billion in credit lines. Analysts have warned that G.M. is burning through $1 billion in cash month, and could run short of operating funds.

But Mr. Fisher said the G.M. board felt confident that Mr. Wagoner’s plan would provide adequate liquidity to ride out the downturn in United States auto sales.

“I feel that management has authorized a series of actions that needed to be taken to make sure there is adequate liquidity.” he said. “Rick and his team are taking some really significant actions.”

G.M.’s vehicle sales in the United States have dropped 18 percent this year, compared with an overall drop in the market of 10 percent.

The company, along with its Detroit rivals Ford Motor and Chrysler, has been particularly hard hit by the collapse in the market for big pickups and sport utility vehicles.

Mr. Fisher said G.M. was not alone in failing to anticipate weak economic conditions and rising gas prices that have driven auto sales to their lowest levels in more than a decade.

“In retrospect, did we anticipate the problems in the housing market and the rise in gas prices?” he said. “No, we didn’t, and others didn’t either.”

However, he expressed confidence that G.M. was on the right track by putting more investment into more fuel-efficient cars and crossover vehicles.

“I believe that 11 of the last 13 vehicles we have brought out have been cars or crossovers, and those weren’t dreamed up in March of this year because of gas prices,” he said

[Beezer]

So, as Taleb says, nationalize the commercial banking functions(the"utility" ones) and for investment banking functions let them insure themselves. No gov insurance in any form.