the people who are most likely to produce the adverse outcome insured against (e.g., bankfailure) are those who most want to take advantage of the insurance.Because depositors havelittle reason to impose discipline on the bank if theyknow it is subject to a safety net, risk-lovingentrepreneurs find the banking industry a particularly attractive one to enter---they know theywill be able to engage in highly risky activities. Even worse, because depositors have so littlereason to monitor the bank's activities if it has a safety net, outright crooks may also findbanking an attractive industry for their activities, because it is easy for them to get away withfraudand theembezzlementof funds.The moral hazard created by the desire to prevent bank failures has presented bankregulators with a particular quandary.Because a failure of a very large bank makes it morelikely that a major systemic financial disruption will occur, bank regulators are naturallyreluctant to allow a big bank to fail and create losses for its depositors. Thus, they are likelyto pursue the misnamed too-big-to-fail policy in which no depositor suffers a loss. (The phrasetoo-big-to-fail is somewhat misleading because when the bank is closed or merged with anotherbank, the managers may be fired and stockholders in the bank lose their investment.)The mainproblem with the too-big-to-fail policy is that it increases the incentives for moral hazard,especially by large banks. Depositors at large banks know that they will not be subject to anylosses, so they have no incentive to monitor the bank and prevent it from risk-taking by pullingout their deposits when it takes on too much risk.The result of the too-big-to-fail policy is thatbig banks take on even greater risks, thus making bank failures more likely. For example,evidence in Boyd and Gertler (1993) found that in the 1980s large banks in the U.S. did takeon riskier loans than smaller banks and this led to higher loan losses for large U.S. banks.It is also important to recognize that different systems to provide a safety net may leadto differing degrees of moral hazard incentives.A deposit insurance scheme might produce asimilar amount of moral hazard to that produced by a less formal scheme in which thegovernment clearly stands ready to support any troubled bank, because in both schemesdepositors know that they will be fully protected by the government. The close equivalence ofthe two schemes is more likely in a banking system with a small number of large banks forwhich the too-big-to-fail policy is operational for.most of the banking system.However, in many situations a formal deposit insurance scheme may lead to greater.9
the people who are most likely to produce the adverse outcome insured against (e.g., bank failure) are those who most want to take advantage of the insurance. Because depositors have little reason to impose discipline on the bank if they know it is subject to a safety net, risk-loving entrepreneurs find the banking industry a particularly attractive one to enter-they know they will be able to engage in highly risky activities. Even worse, because depositors have so little reason to monitor the bank’s activities if it has a safety net, outright crooks may also find banking an attractive industry for their activities, because it is easy for them to get away with fraud and the embezzlement of funds. The moral hazard created by the desire to prevent bank failures has presented bank regulators with a particular quandary. Because a failure of a very large bank makes it more likely that a major systemic financial disruption will occur, bank regulators are naturally reluctant to allow a big bank to fail and create losses for its depositors. Thus, they are likely to pursue the misnamed too-big-to-fail policy in which no depositor suffers a loss. (The phrase too-big-to-fail is somewhat misleading because when the bank is closed or merged with another bank, the managers may be fired and stockholders in the bank lose their investment.) The main problem with the too-big-to-fail policy is that it increases the incentives for moral hazard, especially by large banks. Depositors at large banks know that they will not be subject to any losses, so they have no incentive to monitor the bank and prevent it from risk-taking by pulling out their deposits when it takes on too much risk. The result of the too-big-to-fail policy is that big banks take on even greater risks, thus making bank failures more likely. For example, evidence in Boyd and Gertler (1993) found that in the 1980s large banks in the U.S. did take on riskier loans than smaller banks and this led to higher loan losses for large U.S. banks. It is also important to recognize that different systems to provide a safety net may lead to differing degrees of moral hazard incentives. A deposit insurance scheme might produce a similar amount of moral h=ard to that produced by a less formal scheme in which the government clearly stands ready to support any troubled bank, because in both schemes depositors know that they will be fully protected by the government. The close equivalence of the two schemes is more likely in a banking system with a small number of large banks for which the too-big-to-fail policy is operational for most of the banking system. However, in many situations a formal deposit insurance scheme may lead to greater .9
moral-hazard risk-taking by the banking system than would occur under a less formalgovernment safety net.Deposit insurance protects all depositors, whether the shock to thebanking system is systemic (system-wide) or idiosyncratic (it only affects a single bank that isin trouble).A less formal guarantee provided by the government means that the government isless likely to respond to an idiosyncratic shock than to a systemic shock which threatens thehealth of the banking system. The result is that banks know that depositors may want to protectthemselves and withdraw funds if they think that their bank could be brought down by anidiosyncratic shock, with the result that banks will want to reduce their risk to an idiosyncraticshock.On the other hand, with deposit insurance, the bank does not need to protect itselfagainst idiosyncratic shocks and so has greater incentives to take on more risk. This phenomenawas operational in the United States, particularly in the S&L industry where many smallinstitutions, knowing that deposit insurance protected their depositors under all conditions, wereable to pursue very rapid growth which exposed them to idiosyncratic risks which eventuallybrought them down and imposed large losses on the American taxpayer.Restrictions on Asset Holdings and Bank Capital RequirementsAs we have seen, the moral hazard created by a government safety net encourages toomuch risk-taking on the part of banks.Bank regulations that restrict asset holdings and bankcapital requirements are directed at preventing this moral hazard which can cost taxpayersdearly.Even in the absence of a government safety net, banks still have the moral hazardincentive to take on too much risk.Risky assets may provide the bank with higher earningswhen they pay off; but if they do not pay off and the bank fails, the depositor is left holding thebag.If depositors were able to easily monitor the bank by acquiring information on its risk-taking activities, they would immediately withdraw their deposits if the bank was taking on toomuch risk.Then to prevent such a loss of deposits, the bank would be more likely to reduceits risk-taking activities.Unfortunately,acquiring the information on a bank's balance-sheet andoff-balance-sheet activities that indicates how much risk the bank is taking is a difficult task.10
moral-hazard tisk-taking by the banking system than would occur under a less formal government safety net. Deposit insurance protects all depositors, whether the shock to the banking system is systemic (system-wide) or idiosyncratic (it only affects a single bank that is in trouble). A less formal guarantee provided by the government means that the government is less likely to respond to an idiosyncratic shock than to a systemic shock which threatens the hdth of the banking system. The result is that banks know that depositors may want to protect themselves and withdraw funds if they think that their bank could be brought down by an idiosyncratic shock, with the result that banks will want to reduce their risk to an idiosyncratic shock. On the other hand, with deposit insurance, the bank does not need to protect itself against idiosyncratic shocks and so has greater incentives to take on more risk. This phenomena was operational in the United States, particularly in the S&L industry where many small institutions, knowing that deposit insurance protected their depositors under all conditions, were able to pursue very rapid growth which exposed them to idiosyncratic risks which eventually brought them down and imposed large losses on the American taxpayer. Restrictions on Asset Holdings and Bank Capital Requirements As we have s=n, the moral hmd created by a government safety net encourages too much risk-taking on the part of banks. Bank regulations that restrict asset holdings and bank capital requirements are directed at preventing this moral h~ard which can cost taxpayers dearly. Even in the absence of a government safety net, banks still have the moral hazard incentive to tie on too much risk. Risky assets may provide the bank with higher earnings when they pay offi but if they do not pay off and the bank fails, the depositor is left holding the bag. If depositors were able to easily monitor the bank by acquiring information on its risktaking activities, they would immediately withdraw their deposits if the bank was taking on too much risk. Then to prevent such a loss of deposits, the bank would be more likely to reduce its risk-taking activities. Unfortunately, acquiring the information on a bank’s balance-sheet and off-balance-sheet activities that indicates how much risk the bank is taking is a difficult task. 10
Thus,mostdepositorsareincapableof imposingdiscipline on thebanks which mightpreventbanks from engaging in risky activities.A strong rationale for government regulation to reducerisk-taking on the part of banks therefore exists even in the absence of a government safety net.Bank regulations that restrict banks from holding risky assets such as common stock area direct means of making banks avoid too much risk.Bank regulations also promotediversification which reduces risk by limiting the amount of loans in particular categories or toindividual borrowers.Requirements that banks have sufficient bank capital are another way tochange thebank's incentives to take on less risk.When a bank is forced to have a large amountof equity capital, it has more to lose if it fails and is thus less likely to engage in moral hazardand will pursuelessriskyactivities.Another wayofstatingthepurposeof capital requirementsis that they help to align the banks' incentives more with those of the regulator. In addition,capital requirements can be tied to the amount of risk taking the bank is pursuing, as with theBasle agreements,in effect charging thebanka higher insurancepremiumwhen ittakes on morerisk, thereby discouraging risk takingCharteringandExaminationBecause banks can be used by risk-taking individuals or even by crooks who intend to engagein highly speculative activities, such undesirable people are likely to want to run a bank.Chartering of banks is one method for preventing this adverse selection problem; throughchartering, proposals for new banks are screened to prevent undesirable people from controllingthem.Regular bank examinations,which allow regulators to monitor whether the bank iscomplying with capital requirements and restrictions on asset holdings, also function to limitmoral hazard.In addition,bank examiners can assess whether the bank has the propermanagement controls in placeto prevent fraud or excessive risk taking.With this informationabout a bank's activities, bank examiners can enforce capital requirements and force a bank torevise its management practices if they are jeopardizing the safety and soundness of the bank.Actions takenbyexaminers to reduce moral hazardbypreventing banks from takingon too11
Thus, most depositors areincapable ofimposing discipline on the banks which might prevent banks from engaging in risky activities. A strong rationale for government regulation to reduce risk-taking on the part of banks therefore exists even in the absence of a government safety net. Bank regulations that restrict banks from holding risky assets such as common stock are a direct means of making banks avoid too much risk. Bank regulations also promote diversification which reduces risk by limiting the amount of loans in particular categories or to individud borrowers. Requirements that banks have sufficient bank capital are another way to change the bank’s incentives to take on less risk. When a bank is forced to have a large amount of equity capital, it has more to lose if it fails and is thus less likely to engage in moral huard and will pursue less risky activities. Another way of stating the purpose of capital requirements is that they help to align the banks’ incentives more with those of the regulator. In addition, capital requirements can be tied to the amount of risk taking the bank is pursuing, as with the Basle agreements, in effect charging the bank a higher insurance premium when it takes on more risk, thereby discouraging risk taking. Chartering and Examination Because banks can be used by risk-taking individuals or even by crooks who intend to engage in highly speculative activities, such undesirable people are likely to want to run a bank. Chartering of banks is one method for preventing this adverse selection problem; through chartering, proposals for new banks are scr=ned to prevent undesirable people from controlling them. Regular complying with moral hazard. bank examinations, which allow regulators to monitor whether the bank is capital requirements and restrictions on asset holdings, dso function to limit In addition, bank examiners can assess whether the bank has the proper management controls in place to prevent fraud or excessive risk taking. With this information about a bank’s activities, bank examiners can enforce capital requirements and force a bank to revise its management practices if they are jeopardizing the safety and soundness of the bank. Actions taken by examiners to reduce moral huard by preventing banks from taking on too 11
much risk further help to reduce the adverse selection problem because,with less of anopportunity for risk-taking, risk-loving entrepreneurs will be less likely to be attracted to thebanking industry.DisclosureRequirementsThe free-rider problem described earlier indicates that individual depositors and otherbank creditors will not have enough incentive to produce private information about the qualityof a bank's assets.In order to ensure that there is better information for depositors and themarketplace, regulators can require that banks adhere to certain standard accounting principlesand disclose a wide range of information that helps the market assess the quality of a bank'sportfolio and the amount of the bank's exposure to risk.More public information about therisks incurred by banks and the quality of their portfolio can better enable stockholders, creditorsand depositors to evaluate and monitor banks, and so act as a deterrent to excessive risk-taking.This view is consistent with a recent discussion paper issued by the Euro-currency StandingCommitteeoftheG-10CentralBanks(1994),whichrecommendsthatestimatesoffinancial riskgenerated by firms' own internal risk management systems be adapted for public disclosurepurposes.7 Such information would supplement disclosures based on traditional accountingconventions by providing information about risk exposures and risk management that is notnormally included in conventional balance sheet and income-statement reports.Prompt CorrectiveActionBank regulation can reduce moral hazard and adverse selection problems in the bankingsystem only if regulators pursue prompt corrective action if banks are not complying with theregulatory requirements. This means that bank supervisors must enforce regulations in aconsistent fashion and must not pursue regulatory forbearance, that is, allow banks to keep on7See also the Federal Reserve Bank of New York (1994), which is a companion piece to the Euro-currency Standing Committee's report.12
much risk further help to opportunity for risk-taking, banking industry. reduce the adverse selection problem because, with less of an risk-loving entrepreneurs will be less likely to be attracted to the Disclosure Requirements The free-rider problem described earlier indicates that individual depositors and other bank creditors will not have enough incentive to produce private information about the quality of a bank’s assets. In order to ensure that there is better information for depositors and the marketplace, regulators carI require that banks adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of a bank’s portfolio and the amount of the bank’s exposure to risk. More public information about the risks incurred by banks and the quality of their portfolio can better enable stockholders, creditors and depositors to evaluate and monitor banks, and so act as a deterrent to excessive risk-taking. This view is consistent with a r~ent discussion paper issued by the Euro-currency Standing Committee of the G-10 Central Banks (1994), which rwommends that estimates of financial risk generated by firms’ own internal risk management systems be adapted for public disclosure purposes.7 Such information would supplement disclosures based on traditional accounting conventions by providing information about risk exposures and risk management that is not normally included in conventional balance sheet and income-statement reports. Prompt Corrective Action Bank regulation can reduce moral h-d and adverse selection problems in the banking system only if regulators pursue prompt corrective action if banks are not complying with the regulatory requirements. This means that bank supervisors must enforce regulations in a consistent fashion and must not pursue regulatory forbearance, that is, allow banks to keep on 7See also the Federal Reserve Bank of New York (1994), which is a companion piece to the Eurocurrency Standing Committee’s report. 12
operating as usual despite noncompliance with regulations because it is hoped that the bank'sproblem will goawaywith time.Even ifthebank'snoncompliance is likelytodisappear overtime, by allowing the bank to keep operating as usual, an additional moral hazard problem forthe banking system is created.Other banks, seeing that regulatory forbearance is occurring,willrecognize that they can take greater risks which might lead to noncompliance and yet they areless likely to be punished for it.The result is that their incentives to engage in moral hazardwill have increased.Another way of thinking about this is that even if regulatory forbearanceseems to be an appropriate strategy at the time, it creates incentives in the future that may leadtoundesirable behavior for thebanking system.8It is particularly important that regulatory forbearance not be pursued with regard to bankcapital requirements. If a bank has too lttle capital, its incentives to engage in moral hazardand take big risk increases dramatically. The most extreme case is when the institution iseconomically insolvent and its owners have almost nothing to lose by taking on great risk and"betting the bank": If the bank gets lucky and its risky investments pay off, then the bank getsout of insolvency. Unfortunately,if, as is likely, the risky investments don't pay off, the bank'slosses will mount and the government will be left holding the bag.Why the Regulatory Process Might Not Work as Intended?In order to act in the public interest and lower costs to the deposit insurance agency, wehave seen that regulators have several tasks. They must set tight restrictions on holding assetsthat are too risky, must impose adequate capital requirements, and must not engage in regulatoryforbearance, particularly that which allows insolvent institutions to continue to operate.However, this is not what always occurs in practice.There are two reasons why the regulatory process might not work as intended. The firstis that regulators and bank managers may not have sufficient resources or knowledge to do theirThe problem here is similar to the time inconsistency problem of optimal policy discussed in themacroeconomics literature (see Kydland and Prescott (1977). Although a policy might be optimal expost, it will result in a suboptimal outcome because economic agents are forward looking.13
operating as usual despite noncompliance with regulations because it is hoped that the bank’s problem will go away with time. Even if the bank’s noncompliance is likely to disappw over time, by allowing the bank to keep operating as usual, an additional moral hazard problem for the banking system is created. Other banks, seeing that regulatory forbearance is occurring, will recognize that they can take greater risks which might lead to noncompliance and yet they are less likely to be punished for it. The result is that their incentives to engage in moral huard will have increased. Another way of thinking about this is that even if regulatory forbearance seems to be an appropriate strategy at the time, it creates incentives in the future that may lead to undesirable behavior for the banking system.6 It is particularly important that regulatory forbearance not be pursued with regard to bank capital requirements. If a bank has too little capital, its incentives to engage in moral hazard and take big risk increases dramatically. The most extreme case is when the institution is economically insolvent and its owners have almost nothing to lose by taking on great risk and “betting the bank”: If the bank gets lucky and its risky investments pay off, then the bank gets out of insolvency. Unfortunately, if, as is likely, the risky investments don ‘t pay off, the bank’s losses will mount and the government will be left holding the bag. Why the Regulatory Process Might Not Work as Intended? In order to act in the public interest and lower costs to the deposit insurance agency, we have seen that regulators have several tasks. They must set tight restrictions on holding assets that are too risky, must impose adequate capital requirements, and must not engage in regulatory forbearance, particularly that which allows insolvent institutions to continue to operate. However, this is not what always occurs in practice, There are two reasons why the regulatory process might not work as intended. The first is that regulators and bank managers may not have sufficient resources or knowledge to do their *The problem here is similar to the time inconsistency problem of optimal policy discussed in the macroeconomics literature (see Kydland and Prescott (1977)). Although a policy might be optimal ex post, it will result in a suboptimal outcome because economic agents are forward looking. 13