Bank Stocks Rallied Today, But…

Morale hazard can turn into a darker ‘moral’ hazard

Our current banking crisis — and our government’s responsibility for and response to it — underscore risks facing citizens and taxpayers backing up our banking system.

Government programs like deposit insurance and the Fed’s role as lender of last resort have been sold as “stabilization” schemes. But we are learning again some unlearned lessons from the past. Those lessons relate to two of the most important words in finance — moral hazard.

Insured parties may take more risk, once they are insured. This isn’t necessarily immoral, just rational behavior reacting to the fact that they have insurance.

But at some point, ‘morale’ hazard can become ‘moral’ hazard, particularly if depositors and other creditors of banks are protected by the government and the public purse. Protected parties and their friends in high places may become willfully blind to downside consequences imposed on others, and use the government as a vehicle for gain for well-connected insiders while losses are socialized.

Government officials theoretically serve the general public and the common good. Morale hazard can turn into a darker ‘moral’ hazard when government officials help the chosen few at the expense of the many.

All banks are not alike. And actions like our government took in recent weeks arguably penalize not only taxpayers but good bankers trying to conduct themselves responsibly.

Yes, bank stocks rallied today, after losing about 20% of their value since early March. But how credibly can our government keep bailouts operating? Can public capital sustainably stand behind our banking system, again and again and again? Can we keep kicking the down the road to future taxpayers, and borrow the money? Can we sustainably maintain the value of money, period?

In light of these questions, it is worthy to note that Ed Kane, a professor of finance at Boston College, recently passed away. Ed’s work and career offer lessons for us going forward. His contributions were motivated by concern for taxpayer costs and destabilization flowing from the moral hazard implications of government backstops for our banking system.

A few decades ago, Ed wrote two books warning us about the savings and loan crisis before we knew what hit us. Ed decried how money inflow for irresponsible banks was protected by government programs, which helped them keep making bets, and bigger and bigger bets, even as they became economically insolvent. Regulators looked the other way, then actively abetted the immorality with dishonest accounting principles.

Ed’s recommendations included recognizing taxpayer equity in “too big to fail” banks, reconsidering the framing of fiduciary duties in banking corporations, and developing a culture of regulatory backbone led by Marine Corps-like training programs.

Ed was acutely aware and concerned about something that the old “Chicago School of Economics” emphasized – regulatory capture. Regulated businesses can and do try to control their regulators. The concept was outlined by University of Chicago economist George Stigler in his frequently-cited 1971 article “The Theory of Economic Regulation.

But Stigler wasn’t the first valuable influencer on this idea – even at Chicago. A couple of decades earlier, former Chicago economist and then-United States Senator Paul Douglas penned a volume “Ethics in Government,” and a book titled “Economy in the National Government.” Douglas offered inspirational and timely reviews of problems still afflicting our banking system and government. Each of those books came out in 1952, along with an article Douglas wrote titled “Improvement in Ethical Standards in the Federal Government: Problems and Proposals.” In that latter article, Douglas articulated his related concerns in these terms:

“Certain institutional tendencies or failures of administration tend to defeat public policies. One is the tendency of independent regulatory agencies to surrender their regulator zeal as they age, and to become more and more the protagonists of a clientele industry, and less and less the vigilant defenders of the welfare of consumers or the general public. All too often those who are supposedly being regulated, actually regulate their nominal regulators.”

The time has come to pay more attention to some of these older guys that are no longer with us and to put our money where their mouths were.

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