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Risky business: the free insurance provided to banks


Justin Liu

By

May 20th, 2017


It’s often disappointing to see governments bailing out financial institutions. “Let them fail!”, the public cries out. However, is this alternative any better? Moral hazard explores the consequences of banks knowing they can get away scot-free if things go belly up.
This article first appeared in Short Supply 2017 – check out the full magazine via the Short Supply tab at the top of this page!


Moral hazard (n): Where the actions of one party change to the detriment of the other party after a transaction has taken place.

Imagine what life would be like if every time you got in trouble, whether it be for speeding, theft or even indecent exposure, your parents bailed you out. If you know that your parents are going to be there to rescue you, it may be more tempting to engage in more of this risky behaviour, as the consequences would be shared by your parents and therefore less severe. This is an example of moral hazard, something we have seen consistently in the banking industry, especially in the lead up to the Global Financial Crisis. Despite efforts from governments across the globe to impose greater regulation on banks since the GFC, this behaviour still very much persists today.

Every investment carries some degree of risk, and of course, the higher the risk, the higher the return. Normally before an investment decision, a rational decision maker will balance the return of an investment against its risk and will therefore maintain a spread of low to high risk assets. However, banks and investment firms are aware that governments will bail them out in the event where something goes disastrously wrong. Therefore, instead of investing responsibly in a diversified risk profile, banks may invest more of their assets in high-risk investments, reaping the potential benefits, with the knowledge that if something were to go wrong, the government would be there to bail them out.

What we witnessed at the height of the Global Financial Crisis was a combination of several factors that demonstrate the effects of moral hazard.

In the United States, two organisations, Freddie Mac and Fannie Mae, specialise in buying mortgages and loans, which are packaged into securities that can be sold to investors. This is designed to spur further lending, with the goal of increasing home ownership. Freddie Mac and Fannie Mae are somewhat unique in that they used to be government-run, and hence carried an implicit guarantee by the government.

The combination of relatively high returns coupled with this implicit guarantee from the government led to an increase in mortgage lending in the United States. Demand for mortgage-backed securities skyrocketed, and in order to fuel demand, lenders began to broaden their risk profile to include high-risk borrowers. This led to the adoption of terms such as ‘NINJA’ loans, referring to dealings with borrowers who have ‘No Income, No Job or Assets’. It doesn’t take much common sense to realise that ‘NINJAs’ should not be taking out home loans, as they cannot afford to pay a lender back. Easier access to credit led to higher housing demand and booming house prices. Due to the limited recourse loan system in the U.S, home owners essentially had the option to walk away from their property, leaving lenders with no further recourse over any other assets they may have. When the housing bubble at its peak popped, many of those who had negative equity simply walked away and left lenders in the red.

With the imminent bankruptcy of Freddie Mac and Fannie Mae, the government assumed control over the two organisations again, and hence effectively guaranteed the loans. Investment banks were responsible for securitising loans – the process of packaging up mortgages purchased from retail banks, and creating risky, derivative investments such as mortgage-backed securities. Citigroup, Bank of America, and JP Morgan represented the investment banks that were most entangled with the housing market, and hence had the highest potential for loss. The group required bailouts from the government in order to keep functioning, with the three requiring almost $115 billion USD in aid. [1]

This begs the obvious question – why doesn’t the U.S. Government just refuse to bail financial institutions out? Wouldn’t allowing organisations to experience the error of their ways as punishment finally enable them to learn?

The problem was that during the GFC period, the banks were simply ‘too big to fail’. This is not to say that they were inherently unable to fail, but rather played such a pivotal part in the financial sector and the broader economy such that if those institutions were to fail, there would be disastrous, wide-reaching ramifications. As the consequences of a bank failing are deemed to be unacceptable, the U.S. government had no choice but to rescue troubled institutions; to not do so would run the risk of severe damage to the economy, not just in America but across the whole globe.

One scenario in this immensely complex situation would be immediate deflation. As people lose their trust in the banking system, there is a rush to withdraw deposits. This is concerning due to the fractional reserve nature of our current banking system, where banks lend out more money than they hold as deposits, knowing not all deposits will be withdrawn concurrently. A potential outcome of this scenario is that the bank effectively fails, as it may no longer hold enough reserves to pay out withdrawals. Furthermore, a bank that is either shut down or has no funds left cannot lend, feeding the illiquidity issue. As access to money dwindles, prices drop, as people are no longer able to afford basic necessities. One real-life scenario observed during the Great Depression was that the wealthy were able to purchase assets such as companies and houses for pennies on the dollar, to become immensely rich after the depression. Following the end of the Great Depression, there were huge increases in income inequality, with a large outflow of assets from lower-wealth individuals to higher-wealth individuals.

As far as solutions go, the government could potentially nationalise a bank, but this is effectively the same as bailing them out. There are, however, several regulations and policy tricks that the government can use to its advantage. A series of international agreements known as the Basel Accords mandate that banks conduct certain risk mitigating measures, such as holding minimum amounts of liquid capital. [2] The market can also self-correct in some circumstances. Organisations like Standard & Poor’s and Moody’s assess the creditworthiness of institutions. Higher risk investments cause the rating of the institution to fall, which makes access to credit more difficult or more expensive. Hence, institutions would find it beneficial to keep high-risk investments to a minimum.

Large banking institutions are not inherently evil, but as a result of huge economies of scale, centralisation of economic clout is inevitable. When institutions begin to consolidate and become more important in the economic system, this begs the question of whose interests are being served. Often, it is the shareholders, whose demand for higher profits may come at the cost of the general welfare of the economy. There is ongoing debate about the importance of banks and whether further measures should be taken to address their “too big to fail” status, with the phrase “if it’s too big to fail, it’s too big” being bandied around by Wall Street critics. [3] What is the reasonable expectation here? Do we let these banks fail as a lesson to others, or do we bail them out, knowing full well that they’ll continue to do it again?

Unfortunately, we’re unlikely to come across an answer that completely satisfies all parties. At this stage, the best that governments can do is to continue to implement safeguards and roadblocks that prevent such risky behaviour. However, as history has shown, in the case of the Great Depression, or the more recent European sovereign debt crisis, efforts to reduce risky behaviour and prevent further economic crises have time and time again fallen short. With this in mind, it’ll most likely be a question of when, not if, the next Global Financial Crisis will occur.

 

Justin Liu studies Economics and Arts at Monash University. In his spare time, you might find him debating (arguing) with people over topics that he doesn’t fully understand.

 

[1] Kiel, P. (2008). Show Me the TARP Money. ProPublica. Retrieved 24 May 2017, from https://www.propublica.org/article/bailout-bucks-to-banks-1028.
[2] Basel Process. (2017). Bank for International Settlements. Retrieved 24 May 2017, from http://www.bis.org/about/basel_process.htm?m=1%7C3%7C605
[3] The Federal Reserve. (2010). Causes of the Recent Financial and Economic Crisis. Retrieved from https://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm
Image: ‘Day 40 of Occupy Wall Street in New York, Tuesday, October 25. Photos of protesters and life in Liberty Plaza’ by David Shankbone, http://bit.ly/2qRmMRa. Licence at https://creativecommons.org/licenses/by/3.0.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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