Edited by Christopher J. Green, Eric J. Pentecost and Tom Weyman-Jones
Chapter 6: Moral Hazard
Charles Goodhart INTRODUCTION In their efforts to forestall and to limit the financial crisis, central banks and their governments have extended the safety net to a much wider range of bank, and banking-type, liabilities. With the downside risk of loss thereby limited, the potential for moral hazard is enhanced. We discuss in turn what this may mean for deposits, bank holdings of liquid assets, subordinated debt, equity and remuneration. I discuss the implications, and possible countermeasures, in each instance. Only in the case of equity holders has there been significant loss. Here the problem is not one of moral hazard, but rather how banks can generate a large enough return on equity (ROE) to satisfy investors, at the same time as being constrained by tougher regulation, including limits on leverage. The difficulty of doing so may have significant effects on the future structure of the financial sector. The proponents of narrow banking would have us believe that the only essential elements of a financial system are the payments system and retail deposits. But developments in the recent crisis have revealed that the wider system of credit provision to the private sector is also regarded as crucial to the effective functioning of the economy. Neither Lehman Brothers, Bear Stearns, Fannie Mae, or AIG in the USA, nor IKB, or HRE in Germany were retail deposit banks, or had much direct contact with the payments system. Yet all were rescued, bar Lehman Brothers, and allowing the latter to slide into bankruptcy is...