In the previous two articles we discussed how the crisis was able to occur – essentially I blamed confusion around the lender of last resort function of the Federal Reserve as the catalyst for the crisis, and stated that the European Central Bank’s unwillingness to also take on this role has kept the crisis going. However, these points are only part of the story. To know how to move forward we need to ask how the world found itself in a situation with such high gross debt levels, and then we can ask what this tells us for future regulation.
For at least the two decades leading up to the crisis, we had a financial system where depositors (many of whom were also borrowers) believed that their lending was risk-free, only to suddenly discover that it wasn’t. Although we can justify guaranteeing deposits in the face of a bank run, doing so ignores the effect it has on future behaviour by depositors, borrowers, and financial institutions.
The idea that lenders will act differently when they expect the government to pick up the tab is called “moral hazard”. Specifically, this is a situation where creditors, who know that they will get paid out no matter what happens, are willing to take on more risk than they would have without a government backstop. We also see moral hazard within financial institutions, if banks and other intermediaries were to become complacent in screening the quality of loans, given an expectation they will be bailed out.
For individual loans and individual depositors the potential for moral hazard is not an issue – as if one loan goes bad, or one depositor loses out, they and the financial institution and lenders involved have to face the burden of that. It is only in the case where we expect a large-scale systemic failure in the banking system were the moral hazard problem bites.
A key example of where this can take place (and has taken place) is the housing market. If a single person borrowers a bit too much and can’t pay their mortgage, the bank will just take their house off them and sell it to someone else. However, in the situation where house prices in general are falling and a lot of people have found themselves unable to pay their mortgage (stemming from a recession for example), then banks and their depositors will expect the government to come to the rescue.
This “socialisation” of losses is not just unfair, but inefficient, as it makes credit “too cheap” and leads to “too much” borrowing relative to the fundamentals of the debt market and economy. Seeing this, a central bank can put on its financial stability hat and set binding minimum reserve ratios for classes of assets (eg housing), or impose a tax that represents the risk taxpayers are implicitly taking on due to the central bank being a lender of last resort.
A similar approach was recently formalised by Todd Keister  , where he discussed how banks, as well as the taking on excessive risks, may create contracts that are “too illiquid” in the face of bailouts – and that a tax on short-term liabilities could improve outcomes. The push by the Reserve Bank in recent years to lengthen the maturity of bank liabilities can be seen in this light as part of a the plan to improve overall financial stability in this light.
In the lead-up to the crisis we did not have this sort of regulation in place. Participants in financial markets believed that the Federal Reserve and European Central Bank were lenders of last resort, and so were willing to lend and screen debt in a way that was consistent with this belief. Just like the period 1929-31 period for the Great Depression, 2007-08 was a time when growth disappeared and a number of institutions became insolvent. However, it wasn’t until the US authorities refused to bail out Lehman Brothers, that they showed themselves as unwilling to be a universal lender of last resort and the real crisis started  .
The shadow banking system developed, hidden in plain sight, as a way of avoiding the costs of regulation while still receiving the implicit insurance of having a central bank as a lender of last resort.
At first glance this outcome tells us that we need to regulate the shadow banking system, somehow. However, as discussed by David Aldolfatto (http://andolfatto.blogspot.co.nz/2012/11/shadow-banking.html), the tighter we squeeze, the greater the cost and risk that financial institutions are willing to take on to avoid the regulation!
In his writing, Gary Gorton suggests that we have to take a carrot and stick approach with regards to bank regulation. If we only use the stick, then financial institutions will try to find ways around the regulations, creating the same risks and fragilities that helped cause the Global Financial Crisis. Alan Bollard made a similar point before leaving his position as Reserve Bank governor, stating that supernormal profits in the banking sector are a price we pay in order to ensure financial stability.
And there is the catch. There is, and always will be, a trade-off between safety in the financial system and competition/efficiency during normal times.
We want a banking system that allocates credit efficiently between lenders and borrowers. But with expectations about the future economic outlook incredibly uncertain, this process is very fragile – especially given the quantity and quality of information that needs to be processed by traders if they suddenly need to check whether the institutions they did trust are now insolvent.
History has shown it is not possible to have a perfectly competitive financial sector and a perfectly stable banking sector. To avoid crises like the Great Depression and Global Financial Crisis there has to be government intervention. However, this intervention creates moral hazard and reduces the efficiency of the financial sector in normal times. These are the trade-offs that we have to face, and they are the trade-offs we should be debating as a society now.
 Keister, Todd. 2010. Bailouts and Financial Fragility. Federal Reserve Bank of New York
 The 1929-31 period was significantly worse due to the complete failure of monetary policy during that period – mainly due to implicit and explicit tightening by the Federal Reserve and French Central Bank.