Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Tackling moral hazard to avoid bailouts

Economists worry deeply about the moral hazard problem. A well-functioning financial system is crucial to any market economy in order to match those who have savings to those who have profitable investment projects and need to borrow money.

Be in no doubt, without banks and other financial institutions, everyone would be a lot poorer. But at the same time, the way that the financial system currently operates too often incentivises people in the wrong way.

Economists aren’t interested in banker-bashing for the sake of it. They’re interested in the moral hazard problems that lead to excessive risk-taking, which then leads to financial instability and ultimately to the suffering of ordinary people. Equally, economists worry that the implicit subsidy that banks receive effectively transfers money from relatively poor people to relatively rich people. As the former governor of the Bank of England, Mervyn King, put it:

In good times, banks took the benefits for their employees and shareholders, while in bad times the taxpayer bore the costs. For the banks, it was a case of heads I win, tails you – the taxpayer – lose.

One of the key insights of economics is that people respond to incentives. To fix the financial system, people need to be given the right incentives. One potential solution is to make excessive risk-taking by banks illegal – in terms of the earlier Figure 15-5, simply to shut down the possibility of banks choosing to take the path of ‘excessive risk’, in effect leaving them with no option except to take on moderate amounts of risk.


At least two problems exist with this idea:


How do you decide when a bank is taking on excessive risk? Risk isn’t easy to measure; it’s not like measuring your weight (something we avoid wherever possible!) or how many pints of milk you consume in a month. No agreed-upon way of measuring risk exists.

Therefore the government would have to define somehow what kind of behaviour is acceptable and what kind of behaviour is unacceptable and therefore illegal – no small task. Moreover, no matter how carefully policy makers write the rules, inevitably some loopholes will exist that people will try to exploit. To convince you, think how difficult designing a tax system is in which people can’t avoid paying tax.

Making something illegal isn’t enough. The government needs to be able to detect when excessive risk-taking is occurring. Given that the underlying problem behind moral hazard is that people’s actions are often hidden, detecting when they’ve broken the rules isn’t going to be easy (even more so when they’re purposely trying to obfuscate their actions). Furthermore, even if the government did detect transgressions, the punishments would need to be sufficiently severe such that people would think twice before breaking the rules. This aspect is particularly important given the huge potential financial rewards from breaking the rules.

Instead of trying to shut down the very possibility of taking on excessive risk in financial markets, another method is to make bankers believe that they’ll personally have to pay for any resulting losses – that they won’t be bailed out if they find themselves in trouble. Again, this isn’t straightforward: the problem of systemic risk and the possibility of cascading bank failures (see Chapter 14) mean that any threat not to bail out financial institutions is likely to be seen as incredible.

How can the government make its threat credible? One idea is to break up banks into smaller pieces so that none of them is ‘too big to fail’. Allowing a small bank to fail is unlikely to have systemic consequences; thus, the government can credibly threaten not to bail out financial institutions. For a more detailed look at potential ways to stop future financial crises, turn to Chapter 16.
Chapter 16