Frisking financiers
Fri 2 Dec 2011 by Matt Nolan.

The financial sector is at the very core of our economy, and yet following four years of persistent financial crises there is a feeling that this core is rotten and made up of corporate welfare without any value to society.  However, it is not the greed of bankers that is at fault“ but the incentives that policy makers have given them.  Only by understanding these incentives can we figure out what must be done.

The financial sector has a fairly straightforward role, it helps people who want to lend and people who want to borrow meet.  In a large society, where we struggle to ascertain the risk of lending to a friend, let alone a complete stranger, the financial sector looks through these risks for us, and gives us a borrower we can trust when we want to save.  On the other side, when we want to borrow for something, the financial sector can provide the credit at a rate that is better than any alternative option.

By measuring and pooling risks, financial institutions add real value helping people to smooth their spending overtime, and making it possible for firms and entrepreneurs to invest in profitable activities.

This is all well and good, but for this to work financial institutions require trust. Furthermore, with the way a financial institution functions it can't repay all the individuals lending it money at once as it takes time for people who borrowed from the institution to repay their loans.

The requirement that we trust financial institutions, and the fact they don't have enough cash on hand to repay everyone at a point in time, means that these organisations are vulnerable to bank runs.  A bank run is a situation where people lose faith in the institutionals' ability to pay them back, even if they have the ability to do so overtime. As a result, they race in to get back their money convincing other people that they need to pull out their money as well.  This can lead to perfectly solvent financial institutions becoming effectively insolvent given the immediate demand for cash.

Given the chance of this happening on a large scale the Federal Reserve was set up in 1913.  While we mainly think about central banks as organisations that print money and control inflation, one of their other important roles is to prevent bank runs.

Having this sort of direct back stop in the face of a financial crisis makes a lot of sense.  When the Federal Reserve worked hard to steady the financial system after the collapse of Lehman Brothers in September 2008, they stopped a massive financial crisis from turning into an event akin to the Great Depression.

However, during a crisis it is very hard to tell if a financial organisation is truly insolvent, or just suffering from a bank run. Knowing this, and knowing that large financial organisations are seen as "too big to fail" by government, the central bank backstop leads to banks and other lending institutions taking on too much risk.  This is known as moral hazard.

What does this have to do with "greed", "excessively high wages for financiers", "corporate welfare", and "the crisis"? Everything.

Without having to face the downside of any actions, financial institutions will go for higher risk, higher return, activities.  This increases their returns, knowing that in the case of failure they will be protected.

Rather than criticising people in this industry for responding to the incentives that are put in front of them, the solution here is to ask how we can improve incentives.

A clear solution would be to remove the implicit backstop.  However, this is not a good idea.  Bank runs, and the fragility of the financial system imply that such a backstop is required to avoid another Great Depression and provide the stability required for investment and growth.

The best way to move forward is to accept that there is an issue of moral hazard, and that we have to intervene in the financial industry in order to help correct for that.  Central bankers, including our own Reserve Bank, recognised this prior to the crisis.  Measures like the core funding ratio and minimum capital requirements can and have been introduced in order to limit the ability of financial institutions to take on excessive amounts of risk.

The key risk with this way of controlling moral hazard is that regulators could go too far on the back of undue confidence in their understanding of the world, or create regulations with unforeseen consequences.  However, as long as there is a recognition that we are dealing with moral hazard, and we keep policy in line with this view, our financial sector can again become a strong support for growth.

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