Everything you thought you knew about moral hazard in the banking system is probably wrong. That’s the provocative but compelling message of a new paper by two economic sociologists, Kim Pernell and Jiwook Jung.
Why it matters: Policymakers are deeply concerned about deposit insurance and the way it allows, or even encourages, excessively risky behaviour by banks. This moral hazard argument is often cited as the main reason why deposit insurance shouldn’t be increased to, say, $25 million.
But Pernell and Jung’s data suggest that the opposite is true – that a larger government backstop actually reduces the amount of dangerously risky behaviour that banks engage in.
The big picture: The real question is what causes bank managers to take excessive risks in the first place. Much of the economics literature simply assumes that no matter how high their profits already are, bankers will always seek to increase them unless they are monitored and restrained by the market.
One economist, Columbia’s Charles Calomiris, has identified the government safety net as “the single greatest source of financial fragility” because it limits downside risk while leaving the upside unlimited.
Pernell and Jung, on the other hand, come not from financial economics but from economic sociology. They hypothesise that risk-taking is driven by profitability pressures, and that when it’s hard to make a profit, managers will take ever greater risks to do so.
How it works: If banks can rely on low-cost and stable government-guaranteed deposits, this “dampens the profitability pressures faced by firm managers and reduces their propensity to take excessive risks,” the authors write.
In other words: A banker with a stable base of insured deposits faces far less pressure to make a profit than one who has to struggle to fund each new loan.
What’s more, government regulation itself reduces the pressure on bankers to chase profits, which is one reason why it was relatively unregulated investment banks like Bear Stearns and Lehman Brothers that were the first to fail during the financial crisis, rather than more heavily regulated deposit-taking institutions.
What they found: The best way to settle the argument between economists and sociologists is to look at the empirical evidence rather than what happens in theory.
Looking at bank activity between 1994 and 2015, the paper finds that “greater bank reliance on insured deposits has generally been associated with a net reduced or neutral effect on risk-taking”.
T00-big-to-fail banks also tend to take less risk: “Crossing the $100 billion asset threshold was associated with significantly lower leverage, higher regulatory capital, and less imprudent lending.” (Large banks, however, hold much more derivatives, partly because small banks are generally too small to participate in these markets in the first place).
The bottom line: Government involvement makes banks safer, not riskier.
