Moral Hazard in the Banking Sector: Lessons from the 2008 Financial Crisis and Beyond
Many people have heard the term self-fulfilling prophecy, where believing that something will happen makes it more likely to happen. Researchers have found some truth to this, because belief affects behavior. A quote often attributed to automotive pioneer Henry Ford encourages this: “He who thinks he can, and he who thinks he can’t, are both usually right.” Essentially, confidence in one’s success can create positive actions that lead to the success. Conversely, lack of confidence in one’s success can create negative actions that lead to failure. In either case, the prophecy is fulfilled!
In economics, a similar concept is moral hazard, where a negative action or result that is protected against actually makes the negative action or result more likely to occur. Moral hazard is often analyzed in regard to insurance coverage, with consumers of insurance more likely to engage in behaviors that are protected by the insurance. While few would argue that consuming “too much” healthcare is bad, others would argue that it is harmful to society due to scarcity. If people with excellent health insurance are always seeing the doctor, this could deprive sicker - but less well-insured - patients of available visits.
A less controversial example would be auto insurance. People with generous auto insurance policies are allegedly more likely to engage in riskier driving practices because they know that their vehicle is fully insured. Of course, insurance companies try to correct for this by charging higher premiums to drivers or vehicles they deem riskier, such as young men, sports cars, and off-road SUVs. Drivers who get tickets usually see their premiums increase, as the insurance company now deems them more likely to drive in a risk manner.
Moral Hazard in the Financial Industry: 2008 Bank Bailouts
In 1932, financial and banking systems across the West were on the verge of collapse due to the Great Depression. Governments stepped in and passed reforms to protect the banking industry, including insurance. In the United States and Europe, as well as most other developed countries, governments created deposit insurance programs. Banks would purchase the insurance and be able to advertise all deposits as government-backed; depositors would get their money back in the event of bank failures.
75 years later, the system of government protection of private banks and finance companies was tested in the 2008 financial crisis that triggered the Great Recession. In the United States, the Troubled Asset Relief Program (TARP) spent billions of dollars to “bail out” collapsing investment banks. While TARP did prevent financial industry collapse, it provoked a wave of anger from individuals. Critics of the bailout argued that it was unfair for the U.S. government to protect the [highly-paid] jobs of investment bankers while allowing middle- and working-class families to lose their homes to foreclosure and jobs to layoffs.
Did the 2008 Bailouts Tacitly Encourage Risky Behavior?
By bailing out the banks, did the government tacitly encourage continued excessive risk-taking by investment bankers? One argument that it did was the smaller 2023 bank bailout, where the Federal Deposit Insurance Corporation (FDIC) decided to extend protections to uninsured deposits at smaller banks. Since 2008, investment banks and investors had become more confident in taking risks, perhaps because they believed that the government would swoop in to save the day in the event of catastrophic losses.
Whenever bailouts occur, it inevitably increases confidence that they will also occur in the future. There is public pressure to apply bailouts in all circumstances, at least if wealthy investors got a bailout first. After all, why should small banks be allowed to fail if wealthy investment banks were previously rescued? A similar debate simmered in the United States in recent years over proposed federal student loan forgiveness, with critics arguing that even partial mass debt forgiveness would inevitably lead to pressure for forgiving all student loan debt. This, in turn, could lead to unchecked borrowing, with college students wagering that new loans would also be forgiven due to public pressure.
The Economic Explanation of Moral Hazard: Artificially Reducing Cost
In economic terms, moral hazard occurs whenever the cost of risk-taking is artificially reduced. Under normal free market conditions, the quantity of transactions occurs at the point on a Supply-and-Demand graph where the Demand curve (downsloping) and Supply curve (upsloping) intersect. For non-financial transactions, a similar concept is used: Marginal benefit (MB) and marginal cost (MC).
MB is analogous to Demand, and is downsloping just like the Demand curve. Over time, you receive less and less additional benefit from continuing to perform a task. MC is analogous to Supply, and is upsloping just like the Supply curve. Over time, the additional costs of continuing to perform a task increase. When it comes to risk-taking, this means that the benefits of additional risk taking decline while the costs rise. Eventually, the two shall meet. The point where MB=MC is the amount of activity that should be performed, and is akin to the profit-maximizing point of production in Microeconomics.
When the government helps cover the cost of risk-taking, it shifts the MC curve to the right. Now, at the same quantity of risk-taking, the cost to the risk-taker, such as an investment bank, is lower. This further-right MC curve now intersects with the MB curve at a higher quantity of risk-taking. For society, there is now a negative externality due to an artificially-high level of risk-taking by protected firms: people outside the risk transactions are now harmed.
Reducing Moral Hazard: Regulations to Reduce Need for Bailouts
To reduce the need for bailouts, governments placed greater regulations on banks and financial institutions in the wake of the 2008 financial crisis. The United States enacted significant reforms to reduce banking risk, particularly the Dodd-Frank Act of 2010, which limited banks from speculating (investing in high-risk equities) and putting depositors at risk of harm if they went bankrupt. Internationally, member nations increased regulations on banks under the Basel Committee on Banking Supervision, also known as the Basel Framework. Both sets of regulations required banks to maintain increased levels of capital (financial reserves) after the 2008 financial crisis to reduce their risk of bankruptcy.
By requiring banks to maintain more capital, these regulations limited how much money banks could invest and place at risk of loss. Critics argued that these regulations were economically harmful by preventing businesses from raising funds through investing in equities, swaps, and derivatives, which are riskier than bonds but offer higher rates of return. This pressure to reduce regulations increases during times of economic growth, when such regulations are seen as suppressing growth. Regulations are often reduced, returning moral hazard to the financial market. This cyclical nature of government regulations, particularly in banking and finance, means that moral hazard is unlikely to disappear.
Unintended Consequences of Regulations
Some argue that regulations themselves are not as helpful at reducing risk as they appear, thanks to the ability for consumers and firms to pursue the use of unregulated substitutes for higher profits. In the finance industry, this is known as shadow banking. These are financial firms that operate as unregulated banks, such as online investment banks. Consumers may be unaware that their online bank is not protected by the FDIC and that they could lose all of their deposited funds in the event of a collapse. Shadow banks are often popular because they offer greater convenience for online transactions, lower interest rates on borrowing, and access to investment opportunities.
Widespread news about increased government regulations may also shake consumer confidence in the industry, leading to decreased deposits and thus raising interest rates. This could curtail lending and weaken capital formation by making it more difficult for firms to borrow money to expand. Therefore, while the regulations may decrease risk of loss in the financial industry, they could hinder economic growth by reducing consumer, investor, and business confidence. Therefore, many analysts argue for a balanced approach to reduce risk somewhat (regulations) while still maintaining the availability of credit (bailouts). This means that, for better or worse, moral hazard in the financial industry is here to stay.
