Moral Hazard in Banking
Moral hazard is an asymmetric information problem that occurs after a transaction. In essence, a lender runs the risk that a borrower will engage in activities that are undesirable from the lender's point of view, making it less likely that the loan will be paid back. Gary H. Stern's article, "Managing Moral Hazard with Market Signals: How Regulation Should Change with Banking", addresses the moral hazard problem inherent to the financial safety net provided by the government protection of depositors. Interest rates do not reflect the risk associated with bank activity, which in turn causes banks to finance higher-risk projects with price tags that are not parallel to the risk level.
A solution to the moral hazard problem lies within government supervision and regulation. In the article, Stern challenges the assertion that proposals that rely exclusively on government regulation will satisfy the problem of moral hazard, especially for TBTFs (Too Big to Fail banks). Stern states several factors to support such assertions:
The ability of regulators to contain moral hazard directly is limited, due to the exploitable tactics of regulatory reform.
Limited confidence that regulation and supervision will lead to bank closures before institutions become insolvent.
The limited ability of regulators to asses bank risk due to asymmetric information and reliance of internal bank models that may be inaccurate.
The inherent subjectivity in determining how much risk in banking is too much or too little.
Since banks that are deemed TBTF are regularly shielded from high rates for high risk, larger banks will take on more risk than usual.
After the passage of the FDICIA, two trends have emerged that have further exacerbated efforts in regulating moral hazards. The first trend is increased asset concentration among larger banks. Over time, more assets have flowed into fewer banks, and as a result more TBTFs were incubated in the process. The second trend to emerge is increased complexity of banks. Increase of bank sizes involved not only structural growth but also geographic reach. Larger banks begin to offer a greater scope of offerings. With this plethora of change...