Moral Hazard and Bank Policy

Any safety net can create a moral hazard and certainly there is the idea that since FDIC will take care of investors there is nothing for Bank Management to fear. I disagree in part.
Most people want to achieve success and many actually strive for it. Top managers in any organization certainly work hard to achieve success. These people do not knowingly drive their banks into the ground for instant gain. They know they will be a pariah at their country club tomorrow. How many of Bernie Madoff's friends are visiting with him in jail?
Indeed reputation does play a part in the actions of most Managers.

FDIC insurance shifts some risk from the depositors to the government. The implicit US guarantee on uninsured bank debt also shifts some of the creditor risk to the government.

Too big to fail is about preserving and continuing an existing insolvent financial institution. Bailing out uninsured creditors is not a necessary part of too big to fail, but is commonplace.

Instead of allowing large institutions to fail, impose some additional risks, which are really costs, to uninsured creditors to make them more risk sensitive. For example, if there is a triggering insolvency event, such as FDIC takeover or merger, etc where the FDIC guarantees or assumes any of the uninsured debt or bad assets, impose new costs on uninsured creditors. Some examples of added costs are; a few months delay in interest payments, a reduction in future interest payments, a conversion of a pro rata portion of the uninsured debt to zero coupon debt, etc.

These costs are borne by uninsured creditors, will not interfere with a FDIC closing or merger of a bank, are not a FDIC cost, and will slightly increase creditor risk but leave the current implicit US guarantee in place. It will force uninsured creditors to monitor institutions, and to be selective into which institutions they continue to lend money.

If properly constructed, these added costs will act as a check on the risky behavior of banks and the bank's ability to fund its risky behavior, vary the yield on uninsured bank debt and allow a relative market based risk rating of banks based on the publicly available pricing of the uninsured debt.

Others probably can come up with better ideas for a risk-based cost to uninsured creditors. The concept is to slightly increase the costs to uninsured creditors where there exists a too big to fail practice or an implicit government guarantee. It does not require changing too big to fail now or removing the implicit US guarantee. The only requirement is to have the costs be risk varying, transparent and triggered by a bank insolvency event with the FDIC.

It creates a transition period that puts some of the bank risk back onto uninsured depositors until the US can remove its implicit guarantees and modify too big to fail practices.

I agree with the analysis, but the solution is this:

http://www.the-american-interest.com/article.cfm?piece=600

"To summarize, we’ve got a depository system that’s subject to moral hazard, bank runs and wild swings in the money multiplier. In normal times these risks are theoretical; in times of crisis, they tend to ensure that we suffer maximum feasible calamity. It’s not worth the risk, and limited-purpose banking would eliminate all three problems."

From the NY Times:

http://dealbook.blogs.nytimes.com/2009/10/05/dealbook-dialogue-leo-strine/#comment-321963

“Distilled down, what is most critical is that robust prudential regulation protecting society from risky corporate activity abated, precisely when corporations faced increasingly strong pressures to engage in much riskier endeavors in order to generate short-term results. In the financial sector, this potent cocktail was chased by several governmental interventions to rescue the industry when its “innovative” activities threatened its health, a course of conduct that suggested that the financial industry could take risks other industries could not, because it had a de facto form of federal insurance.”