During the 2007-08 financial crisis, policymakers frequently cited "moral hazard" as a reason not to bail out big banks. The thinking was that if these institutions were saved from the consequences of their behavior—and with taxpayer funding, no less—they would continue to take excessive risks. But the decision to let Lehman Brothers fail in 2008 sharply escalated the crisis, and regulators ultimately intervened, just as they had in the rescue of Long-Term Capital Management in the 1990s, and in the savings and loan crisis of the 1980s.
Exactly who benefits from moral hazard, and how? One obvious answer is the bondholders of financial institutions, who typically, in a rescue, are repaid in full. More surprisingly, though, shareholders also gain from the expectation that some banks are too big to fail, according to research by Bryan Kelly, assistant professor of finance at Chicago Booth.
Kelly and other economists who have studied the moral-hazard phenomenon presented their findings May 15, as part of a Chicago Booth conference on the 30th anniversary of the rescue of Continental Illinois Bank—the first too-big-to-fail institution—and its lessons for the financial system. The conference was organized by Booth's Stigler Center for the Study of Economy and the State.
To measure the impact of bailouts, Kelly constructs a model of what asset markets would look like in the absence of government intervention, and then he compares that model to what actually occurred in the bailout. He uses the prices of options on financial stocks, explaining that options are essentially a form of insurance against a financial-system crash.
During the crisis, the price in the options market of insuring an index of financial-company stocks was surprisingly cheap, "because the government was handing out the same insurance free," in the form of an expected bailout, Kelly said. "There are huge subsidies to equity holders."
From August 2007 to March 2009, the average subsidy to investors in bank stocks was about $50 billion, Kelly finds. The price of the insurance contracts that protected against a crash of the financial system was subsidized about 50%.
The findings show an unintended consequence of government bailouts. "This has a lot of implication going forward for thinking about how we manage systemic risk in the economy," Kelly said. "When you give a bailout guarantee, it distorts market prices."
Similarly, Deniz Anginer, assistant professor of finance at the Pamplin College of Business at Virginia Tech, finds in his research that when investors expect that the government will shield them from losses, those expectations change other aspects of credit markets. For one, implicit bailout guarantees reduce the cost of debt for large financial companies. Also, the cost of their debt becomes less sensitive to changes in risk.
Anginer says the subsidy to corporate debt provided by bailout guarantees could be shifted onto the largest banks by imposing a tax or surcharge. "This would help level the playing field, align risk and return, and promote a more efficient financial system," he said. "It might be better than creating 3,000 pages of new regulations."
The researchers and other conference participants noted that the 2010 Dodd-Frank financial overhaul law, which prohibits taxpayer bailouts, is reducing the incentive for banks to be very large and is likely to diminish the effects of moral hazard. But they cautioned against complacency.
"My view is that the too-big-to-fail problem has receded dramatically," said Philip Strahan, professor and John I. Collins, SJ Chair in Finance at the Carroll School of Management at Boston College. "The danger is that the cycle repeats as memories start to fade and markets adapt."
Strahan, who earned a PhD in economics from the University of Chicago, presented research showing that bailouts give firms incentives to borrow more than they should, to become more interconnected with other financial companies, and to rely more heavily on short-term credit.
In a previous post, economists and policymakers offered their ideas
for ending the subsidies to too-big-to-fail banks and for making the financial system less prone to systemic crises.