This week’s issue of The Economist takes on an issue in the front of many economists’ minds around the world, as well as at the foorefront of our studies in class: moral hazard and the bank bailout. The question at the heart of the article is how can an economy avoid the collapse of major financial institutions while also avoiding the crippling moral hazard of bailouts? Most think of it as a damned-if-you-do-damned-if-you-don’t situation, not anymore. According to Paul Calello and Wilson Ervin:
“A ‘bail-in’ process for bank resolution is a potentially powerful “third option” that confronts this problem head-on. It would give officials the authority to force banks to recapitalise from within, using private capital, not public money…How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework.” For the whole explanation in their article “From bail-out to bail-in” just click on the link above.
The particulars of the bail-in are complex for those (like me) not well versed in the intricacies of the financial sector but the core issues here can be understood fairly easily: moral hazard and sound regulatory policy. If we would have had a more proactive regulatory structure, like the one mentioned by Calello and Ervin, it’s possible that we could have avoided the catastrophic financial collapse without rewarding wreckless investing. For me, it’s especially interesting to think about how this idea could inform our policy from here on out.
The authors go on to mention the merits of this new rescue plan:
“The process would need to be flexible so it could handle a variety of possible situations. But this proposal offers a powerful new way to recapitalise financial institutions using a bank’s own money, rather than that of taxpayers. It would help design resilience and discipline directly into the banking system and prevent individual problems from turning into systemic shocks.”
Some might say that this is an inherent weakness in the bail-in; that having regulators in the breast pocket of bankers is no way to keep a financial sector healthy. Some may see it as trading stability for a “nationalized” finanacial sector. But skeptics really must weigh this concern against the the alternative: banks being inflated with liquidity from tax-payer dollars and the incredible moral hazard it signals to investors that structure problem investments like credit default swaps and ninja loans.
February 9th, 2010 at 12:24 pm
I think this idea is sound. If there were to be any possible solution to help a failing financial institution, using their own assets would be much better than using taxpayers’ dollars. However, I still think failing financial institutions should not be bailed-out or bailed-in. The moral hazard is still present. The failing institution still has little incentives to take responsibility for their poor decisions that got them there in the first place. Therefore, financial institutions should be allowed to fail so society can learn and progress. Also with this mentality, the moral hazard is reduced because financial institutions are more likely to make better decisions, reducing future failures.