At the time of the Global Financial Crisis, in 2008-09, I was fresh out of completing my PhD and still fairly idealistic in terms of what it was possible to do with policy. At that time, it struck me as a bad move to be bailing out the banks that had created such a fragile system. My views have softened significantly since then (although, as noted in my previous post on windfall taxes, I think there is an asymmetry to the relationship between business and government), especially as we've seen the global financial system recover (albeit with a significant increase in central bank balance sheets that is proving difficult to unwind). And now we seem to be at it again, with the US stepping in to save uninsured depositors at Silicon Valley Bank and Signature Bank earlier this week.
Why would saving bank depositors be a bad thing? Moral hazard arises when one of the parties to an agreement has an incentive, after the agreement is made, to act differently than they would have acted without the agreement. Importantly, the agreement doesn't have to be a formal contract. It can be an implicit understanding or expectation.
In this case, if large depositors [*] at failed banks lose all of their deposits, then there is a strong incentive for the depositors to undertake due diligence on their bank. They will want to be sure that their money is safe, and if not, they will bank elsewhere. Or, at least, large depositors will spread their risk by having deposits at multiple banks, rather than banking at a single bank. Because banks know that large depositors are being careful, they will do everything they can to convince depositors that they are safe institutions (and at least some of those actions will actually make the banks less risky). However, when the government develops a reputation for bailing out large depositors, this reduces the incentives for large depositors to undertake due diligence, which in turn reduces the incentives for banks to be safe institutions. This is not to say that banks will be flagrantly risky, only that at the margin, banks will act a little more risky. The moral hazard problem here is that the risky actions of the banks end up costing the large depositors, in the case when the bank fails and if the government doesn't reimburse the large depositors. This would be less likely to happen if the government hadn't created an expectation that they would bail out the large depositors in the first place.
In the current situation in the US, bailing out the large depositors at Silicon Valley Bank and Signature Bank reinforces an expectation at all other banks that the US will bail out large depositors if the bank fails. We can expect riskier behaviour from the banks in the future.
So, should we be against these bailouts? On the Marginal Revolution blog, Tyler Cowen has the most clear-headed explanation of why, in spite of any moral hazard problems, bailing out large depositors was probably the right move. One argument that Cowen makes is that:
An unwillingness to guarantee all the deposits would satisfy the desire to penalize businesses and banks for their mistakes, limit moral hazard, and limit the fiscal liabilities of the public sector. Those are common goals in these debates. Nonetheless unintended secondary consequences kick in, and the final results of that policy may not be as intended.
Once depositors are allowed to take losses, both individuals and institutions will adjust their deposit behavior, and they probably would do so relatively quickly. Smaller banks would receive many fewer deposits, and the giant “too big to fail” banks, such as JP Morgan, would receive many more deposits. Many people know that if depositors at an institution such as JP Morgan were allowed to take losses above 250k, the economy would come crashing down. The federal government would in some manner intervene – whether we like it or not – and depositors at the biggest banks would be protected.
In essence, we would end up centralizing much of our American and foreign capital in our “too big to fail” banks. That would make them all the more too big to fail. It also might boost financial sector concentration in undesirable ways.
To see the perversity of the actual result, we started off wanting to punish banks and depositors for their mistakes. We end up in a world where it is much harder to punish banks and depositors for their mistakes.
Cowen makes additional points (and I encourage you to read his entire post), but the one quoted above is the kicker. If large depositors do not expect to be bailed out, they will only bank at large and safe banks. That will make smaller banks, and probably financial start-ups, less viable. This increases the risks to the financial system if one of the (fewer, larger) remaining banks was to fail. So, policymakers are left with a difficult trade-off: bail out the large depositors and create a moral hazard problem, or not bail out large depositors, and be left with a financial system that is more concentrated, and more vulnerable to future failures. An idealist, like my 2008-09 self, might prefer the second option. However, I'm much more comfortable with where this has gone this time.
One last important point to make is that it appears that the US actions are not bailing out the bankers themselves, only the large depositors. That marks a significant difference between now and the Global Financial Crisis, where it appeared that the bankers mostly got off scot-free. I'm sure that some will argue that the banks found themselves in an unfortunate situation that was unforeseeable and therefore the bankers themselves are not responsible for this outcome. We should reject those arguments, as higher interest rates are not unforeseeable, although they may be unanticipated. Bankers should be better at stress testing for a wide range of future interest rate costs. After all, if it results in higher costs, those costs simply get passed onto their customers. Although that's probably the problem here - passing on higher costs because your bank is stress testing at a more rigorous level than other banks simply makes you less competitive. I guess we will find out in the fullness of time whether there were any consequences for the bankers, and whether there are regulatory changes in relation to banks' testing their vulnerability to future interest rate changes.
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[*] Notice that I restrict the argument here to large depositors. It is unreasonable to expect small depositors to have the time or resources to undertake due diligence on their bank. Also, small depositors can't as easily spread their risk by having deposits at multiple banks. Small depositors are therefore at risk, and have limited means to reduce that risk. So, it is reasonable that small depositors are protected by the government (through deposit insurance, for example).
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