When a bank fails, the consequences can be catastrophic: wrecked livelihoods, economic decline and global depression.
In this article, we discuss moral hazard and regulatory measures, such as capital requirements, to stave off a banking crisis. We then introduce a model we have developed where we analyze the trade-off between competition to attract depositors and cooperation to enhance liquidity. We evaluate different policy tools with the objective of promoting financial stability.
Banking Regulation – the Unintended Risks
The Great Financial Crisis of 2008 reignited a fierce debate about banking risk and, in particular, the stability of the global financial system. The regulator, in its desire to prevent crises, can actually make them more severe and their consequences more unpredictable. In this sense, the problem of moral hazard has been a research topic on which countless academic papers have been written and published, yet the specter of the next financial crisis continues to loom across the economic landscape.
The traditional role of banks as financial intermediaries that facilitate the transformation of liquid funds provided by depositors into long-term loans makes the banking system inherently fragile. In a world where depositors are too atomistic to know with precision the quality and characteristics of the loans made by the banks where they hold their deposits, these depositors may be tempted to respond to unclear signals about the evolution of those loans to ensure the recovery of their deposits. Stated differently, if customers feel their bank is ‘playing’ with their money, they might pull their deposits out and stuff their cash ‘under the mattress’ or deposit it with a more cautious bank.
Without a guarantee that their funds will be available at all times, depositors can generate (or accelerate) crises due to liquidity problems— and not only due to bad business decisions from the banks with which they work. To avoid such a run on the banks, most countries in the world have some type of deposit insurance system that guarantees depositors up to a certain amount, in the event the banks where they keep their deposits go bankrupt.
The Definition of Moral Hazard
Among other tools, these regulatory measures (e.g., bailouts for banks that are systemically important or highly connected to other banks and companies) make it highly unlikely that a big bank would not be rescued in the event of bankruptcy. Indeed, the costs of not doing so may exceed the cost of a bailout (the direct costs of not rescuing them plus higher unemployment, a crippling credit crunch or other knock-on effects). This has led many banks to be tempted to take on more risk than they should from a financial stability point of view. This is called ‘moral hazard’. One of the most common ways to prevent moral hazard has been capital requirements. However, their impact is not always clear, and many economists do not agree on their effectiveness in terms of reducing risk.
Capital Requirements To Create a Liquidity Buffer
Are capital requirements effective in preventing crises? Two lines of research address this question and have reported starkly different results. One suggests that by increasing their capital requirements, bankers have more to lose, since they use their own funds in large part to finance their investments. The theory says that they should behave more prudently if they risk losing their own money; this is what is called the “skin in the game” effect.
However, another strain of the literature does not agree with this position, arguing that by increasing capital buffer requirements, bankers may be incentivized to make even larger bets in order to obtain higher returns; this is what is called the “lower charter value” effect. In order to align the incentives of bankers with those of the regulator, other measures have been put forth to complement capital requirements such as loan controls, maximum limits on the interest rate charged by banks or even reducing the scope of state guarantees… all in the name of encouraging more sober lending practices.
Competition vs Cooperation in Banking
In a recent article (Augusto Hasman & Margarita Samartín, Competition, coinsurance and moral hazard in banking, Journal of Banking & Finance, Vol. 164, 2024), we analyze the problems that can arise when banks are faced with the dilemma of competing or cooperating. Banks can establish links to reduce their liquidity needs, but such ties expose them to greater systemic risk. If one of the banks, with which they have these ties, falls ill, the other banks in the system may be exposed to contagion problems and eventually get infected by the same crisis. Yet, banks continue to compete, in many cases with the same banks, to attract depositors.
In our model, banks are funded by depositors affected by uncertain liquidity needs. In the absence of the interbank market, banks would have to keep a cushion against the liquidity shock, hence reducing the amount invested long term. The interbank market offers the possibility of establishing ties between banks by providing coinsurance against the risk of illiquidity, and reducing the investment in liquid funds. However, these increased funds available for other long-term investments can have a double-edged effect.
On the one hand, the interbank market, by reducing the need to maintain liquid funds, allows part of these funds to be channeled into long-term investments, increasing their value. This reduces moral hazard because it increases banks’ charter value (i.e., the overall value of the bank's business and franchise). On the other hand, this greater availability of funds to invest can increase the temptation to dedicate them to other less secure uses. Awash in liquidity, a bank might start to make unwise investment decisions.
A Surety Bond To Bolster Charter Value
In our article, we devise, develop and analyze a regulatory policy measure that restores charter value by facilitating cooperation and promoting economic activity. Our measure consists of a surety bond à la Dwyer et al. (Dwyer, P.G., Hasman, A. and Samartín, M., Surety Bonds and Moral Hazard in Banking, Journal of Financial Stability, Vol. 62, 1-10, 2022). It consists in investing part of investors' capital in a safe asset, (such as Tbills or other assets uncorrelated with the banking business), that only generates returns when the bank's business is doing well, but that is lost in the event of bankruptcy. Our measure has the appeal of not reducing competition levels and is more effective than solely targeting capital requirements.
The novelty of our proposed policy measure also lies in the fact that we are able to study it in a dynamic context, where banks compete to attract deposits while cooperating to reduce their liquidity holdings. The dynamic framework allows us to capture the effects on the charter value of banks. This is a theoretical exercise that researchers and policymakers often use to discuss the possible impacts of regulation. By studying models of this type, we can better understand reality while evaluating the effects of introducing new regulatory measures and comparing them with existing ones.
