Bailing Out Banks: Can You Say "Moral Hazard"?

Northern Rock, a smallish bank in the UK, recently faced a potential liquidity shortage when it could no longer convert some of its assets [see Tim Worstall's comment for the correct details] into ready cash because nobody would buy those assets at any price other than a substantial discount until they had a better idea of the actual risk involved. For the most part the assets will pay off over time, and no one seriously questioned the solvency of Northern Rock. The bank just needed to borrow some funds to tide them over.



And the Bank of England stepped up to provide these funds. That's the way the banking system is supposed to work.



Meanwhile if depositors' accounts are insured (up to fairly high limits), they were in no danger of losing anything (other than their own short-term liquidity) even if Northern Rock had been insolvent. And if depositors' accounts are not fully insured, there is no good argument for asking all the taxpayers to bail them out ex post. It's like telling folks they don't need to pay their insurance premia because the gubmnt will provide the insurance for them anyway; under such a policy, only chumps and patsies buy insurance as everyone comes to rely on the gubmnt.



Why depositors decided to stage runs on Northern Rock escapes me. But maybe had I been there with all my money tied up in Northern Rock, I'd have been a bit panicky, too, as I saw others queuing up for their cash. (though I'd have probably tried to open an account at a different bank and then transfer the funds electronically via the internet rather than stand in the long queues). [for an interesting historical perspective, Tim Worstall has this. Also see this by Tim Worstall.]



If it turns out the bank is, indeed, insolvent, the officers of the bank will (or should!) likely lose their jobs, depositors will still get their money (up to the insurance cap, or lose their money if they didn't make sure their deposits were insured*) and the stockholders of the bank lose their money. That's the way a good banking system should operate.



But now the British gubmnt has buggered it all up. They've told bankers (this is a very loose paraphrase)(see Stephen Pollard)

Go ahead. Take big risks with your depositors' money. If the risks pay off, you will become fabulously rich and your depositors and stockholders will be happy. If your risks don't pay off, the nanny state will be here to bail you out (in the guise of bailing out the little-guy depositors). Taking more risk is a winning proposition for you and you'll never lose a cent.

I once asked David Laidler, colleague and world-class monetary theorist, if we could afford NOT to let a bank go under if it was indeed poorly managed to the point of insolvency. He fully understood the point I was making: The risks involved with a bank's lending, buying commercial paper, etc. are complex to the point that it would be inefficient to ask depositors to bear those risks indirectly. From that perspective, deposit insurance might be a good idea (and it surely would be if it were optional). But bailing out banks merely rewards inefficient risk-taking by managers, and the cost of bearing that risk is fobbed off onto the taxpayers.



But now that the Brit gubmnt has promised to bail out the banks, no matter what risks they take, watch for much more gubmnt regulation and intervention, telling them what risks they will be allowed to take. And then watch for entry from near banks (e.g. ING) and other institutions, in an attempt to circumvent the gubmnt interventions. I give 'em ten to fifteen years.



* In response to an e-mail question about deposit insurance, Tim Worstall tells me,

There is gubmint provided. 100% up to £2,000 and then 90% up to £34,000 (or thereabouts).



The fall out from this is likely to be that there'll be something very like FDIC: £100,000 financed from a levy upon the deposit taking institutions.

But the question of whether gubmnt provided deposit insurance is a slam-dunk efficiency-enhancing policy is far from settled. See this. What puzzles me is why private insurance hasn't become more common for institutions with many large deposits.