Posted by: Dirk | June 22, 2009

Gamble for Redemption

Nouriel Roubini and Brad Setser, Bail-outs or bail-ins? Responding to Financial Crisis in Emerging Economies, 2004, p.99:

Yet other models highlight how the existence of a lender of last resort – or more commonly, mispriced deposit insurance that eliminates the risk of a run – creates moral hazard. The incentives of the bank’s owners are not necessarily aligned with the interests of the bank’s depositors or the source of the deposit insurance. If the banks lack sufficient capital, the bank’s owners have an incentive to “gamble for redemption” by making risky loans. If the risky loans succeed, the bank’s owners win. If they fail, the owners do not lose much. The bank’s capital is already gone. Since the deposits are insured, the “insurer” – in this case, the domestic government – bears any additional losses. Thus, liquidity support, which reduces the risk of losses by depositors, risks creating moral hazard even if it prevents liquidity runs. In the domestic context, such distortions can be reduced by “incentive compatible deposit insurance” (i.e., appropriately priced deposit insurance) and by regulating and supervising the banks that benefit from access to the lender of last resort. The central bank or the regulatory authority also has the power to seize a bank, change its management, restructure it, merge it with other banks, or even liquidate it – all of which should strengthen incentives for responsible bank management.

Praise for this book includes Jeffrey Sachs, Lawrence Summers, Kenneth Rogoff, Barry Eichengreen and Jeromin Zettelmeyer. So, obviously neither Europe nor the US are following the above guidelines regarding moral hazard. Of course, these economies are not emerging economies. Actually, they are quite the opposite right now: faltering economies.

Either the worst of the crisis is over after the summer and Roubini and Setser’s moral hazard does not apply to developed economies, or … – I really don’t want to think about the alternative. (However, I have been preparing myself by reading more on the Great Depression.)

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