In 2020, the Fed promised to maintain an average inflation rate of 2%. They abandoned that promise as soon as it was convenient to do so.
After the 2008 banking crisis, the government promised to refrain from bailing out small and mid-sized banks and instead allow FDIC to handle the situation. According to Bloomberg, that promise is also being reneged on:
US authorities raced on Sunday to stem jitters about the health of the nation’s financial system, pledging to fully protect all depositors’ money following the collapse of Silicon Valley Bank while also giving any banks squeezed for cash easier terms on short-term loans. . . .
The Fed in a separate statement said it’s creating a new “Bank Term Funding Program” that offers loans to banks under easier terms than are typically provided by the central bank.
Fed officials said on a briefing call that the facility will be big enough to protect uninsured deposits in the wider US banking system.
This is even worse than only bailing out SVB. It means that other banks will get similar protection. It is tempting to think that bailouts solve the problem, but in fact they just make it worse. The underlying problem is moral hazard, and each bailout makes people behave even more recklessly going forward.
One common misconception is that moral hazard is not a problem because bank shareholders at SVB will lose a lot of money. That misses the point. Moral hazard doesn’t cause banks to want to fail, but it does tilt the optimal bank strategy toward a socially excessive amount of risk taking.
Obviously most banks don’t fail even under our dysfunctional system, but the problem is getting steadily worse despite an endless series of regulatory fixes that don’t address the root cause of the problem. When regulators plug one gap, banks find an alternative method of loading up on risk.
Another misconception is that we cannot reduce moral hazard because big depositors don’t pay attention to bank risk. Of course they don’t. Why should they? But what if they feared losing their money?
The only solution is to reduce moral hazard. Instead, we are moving in exactly the opposite direction—adding to moral hazard. Financial crises will get ever more frequent in the decades ahead.
PS. This made me roll my eyes:
SVB depositors “will have access to all of their money starting Monday, March 13,” the government said in a statement, adding that taxpayers won’t be responsible for any losses associated with SVB’s resolution.
No cost to taxpayers? Let me guess—the Treasury has a magic wand.
READER COMMENTS
BC
Mar 13 2023 at 4:39am
It’s become clear to me over the last few days that what we call moral hazard is actually the Fed’s (and other regulators’) intended outcome. In their statement announcing the SVB bailout, they say, “This step will ensure that the U.S. banking system continues to perform its vital roles of protecting deposits and providing access to credit to households and businesses.” Providing “access to credit” means making illiquid risky investments, whether its long-term treasuries in the case of SVB or mortgages and other loans. So, US regulators define the “vital role” of the banking system to be a system that takes taxpayer-backstopped short-term deposits (“protecting deposits”) to make illiquid risky investments (“access to credit”).
Regulators can’t seem to countenance that nowadays we have plenty of investment funds that can invest in those illiquid risky investments, e.g. securitized loans and mortgages and certainly long-term treasuries. So, it may not be so “vital” to backstop banks to get them to do it. In fact, the Fed quashed the Narrow Bank, which was going to limit itself to investing deposits in only liquid, short term investments (interest-paying reserves). The Fed was worried that, if too many customers moved their deposits to the Narrow Bank, then that would hurt traditional banks’ ability to provide access to credit.
That’s why the “problem is getting steadily worse.” It’s not “despite” the regulatory fixes. The “root cause” of the problem is that regulators *want* a banking system in which banks are able to make illiquid risky investments and view taxpayer-provided backstops as essential to enabling (what regulators perceive to be) that “vital role” for banks. We won’t be able to fix the problem until regulators stop believing that it’s “vital” that banks provide access to credit.
Scott Sumner
Mar 13 2023 at 12:18pm
Exactly. The excess risk taking is a feature, not a bug. There’s no realistic fix for the problem because this is what Congress wants.
Jose Pablo
Mar 13 2023 at 2:54pm
That’s a very good one.
Why we don’t have yet “narrow banks” (as so many prominent economist have been advocating for decades) for deposits that should be available on demand and let the lending activities to special purpose funds with clear prospects that allow investors to know the risks and liquidity rules that can minimize these kind of problems?
Even worse, why, in particular, the regulators took active steps to be sure that narrow banks could not be profitable?
https://johnhcochrane.blogspot.com/2019/03/fed-vs-narrow-banks.html
nobody.really
Mar 13 2023 at 5:05am
Well, kinda; government can simply print money.
But that’s not what we’re discussing here. The Treasury is saying that they’ll back up depositors from proceeds from the federal Deposit Insurance Fund–and they’re replenish the fund with a “special assessment” on banks. Ergo, banks–not taxpayers–will bear the incidence of the new policy. Who bears the ultimate burden? Hard to say. If, in the absence of the new policy, banks would begin failing willy-nilly, then arguably shareholders and bondholders would be the primary beneficiaries of the new policy and might gladly bear the additional insurance costs.
I agree with the view that deposit insurance likely makes bank management pursue greater risk than they would otherwise pursue. But can we say that the socially optimal level of risk is the same as the level of risk individuals would choose for themselves? In another thread I speculated that states authorize limits on liability for certain investors based on the belief that, in the absence of this policy, investors would fail to make adequate investments. Maybe the same dynamics influence FDIC policies?
Mark Brophy
Mar 13 2023 at 5:36am
It’s not hard to say who bears the ultimate burden, it’s the depositors at the taxed banks. The banks will pass on their extra costs to their customers.
robc
Mar 13 2023 at 9:28am
Insurance doesn’t cause moral hazard.
Private insurance is no problem. The good thing is private insurers will let the uninsured fail.
End the FDIC. Let banks buy private insurance. I am sure General Re would be happy to write them up a policy (or a policy for their insurance companies anyway).
Jose Pablo
Mar 13 2023 at 2:36pm
I am sure General Re would be happy to write them up a policy
Sure they will do!
And if things go south General Re can always count on the taxpayer to resque them … as we did with AIG in 2008
Scott Sumner
Mar 13 2023 at 12:20pm
Printing money creates an inflation tax on existing money holders.
FDIC are mandatory; they are a tax that eventually falls on bank customers.
No free lunch.
nobody.really
Mar 13 2023 at 2:31pm
Sure, there are no free lunches. But some lunches are cheaper than others. It is not clear to me that operating a bank in the world as it existed prior to the FDIC–in particular, from 1893 to 1933–was so much cheaper than operating a bank today.
Jose Pablo
Mar 13 2023 at 2:59pm
There is a much cheaper answer (markets have this way of figuring out an optimal solution to any problem, you know).
The question is why the FED want to quash this solution.
https://johnhcochrane.blogspot.com/2019/03/fed-vs-narrow-banks.html
Maybe to make their job more meaningful?
Man, the reach for meaning of some people have terrible consequences
nobody.really
Mar 13 2023 at 3:36pm
Well, you’ve put your finger on the problem: I don’t know this. I still believe in market imperfections. I realize that may put me in the minority here, but I sense I have a lot of company among economists more generally.
As Mark Twain famously said, “It’s not that people don’t know. It’s that they know so much that ain’t so.” And the fact that there’s no evidence that Mark Twain ever said this only makes the admonition MORE persuasive.
Jose Pablo
Mar 13 2023 at 4:26pm
I don’t know this. I still believe in market imperfections.
Maybe yes or maybe not. But in this particular case (banking) the market did came up with a very good solution and the Fed dutifully quashed it
https://johnhcochrane.blogspot.com/2019/03/fed-vs-narrow-banks.html
nobody.really
Mar 13 2023 at 4:07pm
Thanks to Sumner for taking the time to addressing my (and other people’s) queries in a new thread. Let the conversation continue there.
Moneyless Economy Initiative
Mar 13 2023 at 6:09am
The root of the problem is capital. Oh, and still using money as a tool for upholding power and influence when human civilization finally has the resources and scientific expertise today to convert labor, materials, and information into daily goods and services? We could be generating universal protections for all, keeping pace with the speed of progress, instead we stick with a global political economy that can’t even reduce global warming or pollution. Roll eyes? Ha!
Michael Sandifer
Mar 13 2023 at 9:20am
I hoped, and expected, that such actions taken over the weekend would at least stem the potential crisis temporarily, if not prevent it entirely, agreeing that moral hazard is increased in the longer run. But so far, these bailouts and promised bailouts aren’t even offering much of a temporary reprieve. I’m growing increasingly concerned that we are now in the midst of another financial crisis, much larger than I would have imagined.
Michael Sandifer
Mar 13 2023 at 9:55am
I’ve been trying to think through why the banks would still be under such pressure, given broad guarantees of coverage of deposits and the Fed’s new lending facility, which would recognize bonds at par for the purpose of collateral.
The first complete thought that comes to mind is that it is perhaps too late for at least some for liquidity solutions. There may be some combination of real solvency issues and/or the liquidity concerns that are so broad, that markets are currently skeptical that the resources the government has to deal with the crisis will be sufficient.
This could be bad.
Andrew
Mar 13 2023 at 11:55am
I think your thoughts contain the answer to the question. You wonder why there is still an issue given “the Fed’s new lending facility, which would recognize bonds at par for the purpose of collateral.” This isn’t about liquidity at all, this is clearly a procedure aimed at solvency. It’s not that they can’t sell the bonds, it’s that the bonds aren’t worth what they need to be. The fed will now loan at above the market value of the bonds, creating a temporary illusion of solvency, but someone will need to make up the shortfall eventually.
Following this reasoning, one might have some serious concerns about the promise not to have taxpayers cover the FDIC bailout. Requiring other banks to cover FDIC payouts and shortfalls when the banks are already having solvency issues could be a mechanism of contagion rather than a solution to the problem.
Given $620 billion of unrealized losses, one wonders how many banks are currently insolvent but limping along due to the FDIC backstop.
Scott Sumner
Mar 13 2023 at 12:22pm
Given the structure of our banking system, these sorts of crises are inevitable. It’s just a question of when and where.
Jeremy Goodridge
Mar 13 2023 at 12:43pm
Hi Scott,
Here’s Krugman on moral hazard in a tweet today:
“But on moral hazard: I don’t think expectations of a bailout created this mess. The depositors weren’t that smart.”
“I mean, if you’re totally into crypto, how likely that you’re carefully thinking through the logic of deposit insurance? You haven’t even figured out what money is!”
So Krugman doesn’t think moral hazard plays a role here.
Curious to hear your thoughts on Krugman’s particular reasons for not attributing these problems to moral hazard — depositors already didn’t know what they were doing. Is there data available that might suggest that moral hazard somehow played (or didn’t play) a role in the back of their minds?
Thanks again,
Jeremy
Michael Sandifer
Mar 13 2023 at 12:58pm
I think Scott’s right, that insuring deposits will force banks in a competitive market to take more risks than they otherwise would. It could be why former CitiGroup CEO Chuck Prince once said, “As long as the music is playing, you’ve got to get up and dance.”
Even bank CEOs who know they’re taking on dangerous risks in such markets also know that if they don’t do so, they will be replaced by someone who will.
Richard W Fulmer
Mar 13 2023 at 1:03pm
Thus the need for all-knowing, all-seeing people like Dr. Krugman to protect depositors – and people in general – from themselves.
nobody.really
Mar 13 2023 at 3:02pm
I can’t speak to the money side of this. But I detect an argument about rational ignorance, and I might have a firmer grasp on those dynamics.
If I lived under circumstances where panthers or yellow fever were common, I expect I might have developed strategies to protect myself. Instead, I’ve been told that other people have managed these threats for me, and instead I’ve been socialized to avoid more pressing risks (say, muggers and pickpockets). In short, I am rationally ignorant about how to manage the threat of panthers and yellow fever.
Likewise, I don’t investigate the solvency of the financial institutions in which keep my money because I’ve been told that others have managed that risk for me. As a result, I am rationally ignorant of that threat, too. But if I lived in a world where I had not been told that others have managed that risk, I might have learned to take steps to manage that risk.
I sense that Krugman is arguing that because people act recklessly regarding their finances today, we can infer that they would have acted recklessly regardless of public policy. But if policy had been different, people would have grown up (“been socialized”) to guard against certain financial risks. In short, circumstances dictate when it makes sense to be rationally ignorant about a topic. If we had changed the circumstance, people would change the topics upon which they educate themselves. And I expect this dynamic holds even if the people themselves are unaware of how circumstances have changed the environments in which they are socialized–that is, even if people are not engaged in conscious, strategic decision-making about risk-taking. (After all, did you ever made a conscious decision to refrain from educating yourself about how to guard against panthers?)
vince
Mar 13 2023 at 4:22pm
I don’t either, but I’m quite aware of the $250k FDIC protection.
I agree with Scott:
vince
Mar 13 2023 at 4:50pm
Then again, they needed to be smarter than Basel committee that designed the regulatory system. Per the most recent SVB 10K: The regulatory capital ratios of SVB Financial and the Bank also exceeded the “well capitalized” requirements under relevant regulations.
Scott Sumner
Mar 13 2023 at 3:53pm
“But on moral hazard: I don’t think expectations of a bailout created this mess. The depositors weren’t that smart.”
He’s reversing cause and effect. They weren’t that smart because of moral hazard. Why be smart when there’s no reason to be smart? I assure you that big depositors were very smart before FDIC.
Richard W Fulmer
Mar 13 2023 at 4:01pm
Exactly. Back in the 1980s, I had two different banks fail out from under me and I didn’t lose a penny. I chose them solely because of their convenient locations. There was no need to look into the management of the firms or to check their balance sheets because, even if they were badly run, there was zero risk. The cost of investigating them wasn’t worth the benefit.
Jose Pablo
Mar 13 2023 at 2:42pm
because bank shareholders at SVB will lose a lot of money.
This is a truly good one coming from the authorities. Together with the “no cost to taxpayer” that you mention makes me much more than rolling my eyes.
No one in the finantial instution orchestating this bail-out has taken a look at the share price of medium regional banks this morning after the anouncement? Or to this:
https://www.barrons.com/amp/articles/bitcoin-crypto-markets-today-85d1c0b
Is this not a “bail-out”? How should we call it? … waiting instructions from the Ministry of Truth
Dylan
Mar 13 2023 at 4:08pm
Not sure I’m following. Bank stocks were hammered today, they recovered a bit at the close, but still Schwab was off by 11%, First Republic down by 60%. Am I missing some banks where this has been good for shareholders?
Jose Pablo
Mar 13 2023 at 4:21pm
Counterfactuals are tricky, they were even more hammered at the opening. Even the S&P as a whole went from 3808.88 at 9:38 to 3901.30 at 11:30. 2.4% up in a couple of hours.
But this is feature not a bug, the FED also rescue security markets in March 2020 with a “special lending program” to shore-up (no pun intended) cruise line debt
Same old
Jose Pablo
Mar 13 2023 at 4:23pm
The point is, I guess, there are more bailouts that the eye can see.
Dylan
Mar 14 2023 at 7:17am
I’m still not sure I’m following the logic here. Here’s the timeline as I understand. SVB info about being in trouble comes out on Wednesday (?). By Friday, Feds announce they are taking it over. Bank stocks fall on Friday, before recovering a bit by the end of the day. Sunday is the announcement that depositors will be made whole, but not investors. Monday morning, bank stocks plummet even further, before recovering somewhat by the end of the day. None of that suggests a bailout for shareholders to me, except maybe by stopping a bank run on an otherwise solvent bank.
vince
Mar 13 2023 at 4:40pm
If the lending facility were 5 percent while the market return on such risky credit were 20 percent, that’s a loss to taxpayers.
Travis Allison
Mar 13 2023 at 8:11pm
Absent the FDIC, there would probably be private bank insurers, probably made up of groups of banks that audited each other to create public trust and provided some type of guarantee to depositors. For a *great* history of the origin of clearing houses and central banks, read this:
https://fraser.stlouisfed.org/title/business-review-federal-reserve-bank-philadelphia-5580/january-february-1984-557614/private-clearinghouses-origins-central-banking-523625
So I think in any banking system, due to the liquidity mismatch between assets and liabilities, there’s going to be some sort of institutional structure that handles that mismatch. Plus there needs to be some sort of institution to make sure that a bank is not lying about its balance sheet. The private market realized that long before the FDIC was formed.