Bailing Out The Banking Sector and Moral Hazard

A common concept in economics is the idea of moral hazard. Basically, this states that a decision can influence future behaviour - often for the worse.

Suppose you have a child who gets into debt. If you unconditionally bail him out and pay off his debts, he may think "great. I can spend whatever I like, as I know my parents will bail me out!" So, in the future, he just gets into a bigger debt . This is moral hazard. At first glance it seems sense to pay off his credit card debt and avoid paying interest payments at 17%; this saves the family money in the future. However, by paying off his debt, it encourages bad economic decisions. This is why a parent would be reluctant to pay off a child's debts without making them commit to changing their behaviour.

• Suppose a bank makes a series of bad loans to people with poor credit histories. Maybe they sell mortgages to people who have no chance of paying them back. (sound familiar?)
• In a few years time, the borrowers unexpectedly start to default on their debt. The bank starts to lose money and could be threatened with bankruptcy.
• The problem is that if a bank goes bankrupt it would seriously undermine the whole financial sector. If people see one bank go under they may start withdrawing their money from all banks. This could cause a financial meltdown. In 2007, the UK experienced this panic as investors rushed to withdraw savings from Northern Rock. In the 1930s, lack of confidence in the banking sector caused people to withdraw their savings and many small and medium sized banks went bankrupt.

So the Government and Federal Reserve have a dilemma. If they do nothing, they risk financial meltdown in the banking sector. However, if they intervene and save the bank, they are in a way saving a bank from it's own bad decisions. Furthermore, it risks moral hazard. If banks know they will always get bailed out they can worry less about making bad loans. If things go pear shaped again the government will always bail them out.

Arguably, the way the government responded to the dotcom bubble of 2000 created moral hazard. The dot com boom and bust caused a risk of a recession as share prices plummeted. Therefore, the Fed cut interest rates very aggressively, close to 1%. This helped avoid a deep recession in 2000-01, but, it created a climate of lax lending in the period 2002-06 and another boom and bust, this time in the mortgage sector. The financial authorities overcome one problem only to create a bigger one in the future.

What is the Solution?

One solution is to bail out the banks and prevent immediate short term problems. But, then the government and / or financial regulators have a responsibility to regulate the banking sector to make sure bad loans are not repeated. Of course, this is easier said than done; but, these issues of moral hazard present a real dilemma for Monetary authorities - To risk financial meltdown or 'reward' bad behaviour.

What do you think? Should the government be bailing out banks who make bad decisions?