Controlling Moral Hazard in Bank Resolutions: Comparative Policies & Considerations in System Design
32 Pages Posted: 23 Apr 2008
Date Written: July 2006
This paper reviews the key legal and policy measures designed to limit moral hazard in bank insolvency systems and compares and explores how existing national insolvency systems have implemented these principles. While many legal systems include prohibitions or limitations on the use of public money to bailout a failing bank, many systems do not provide effective alternatives to a bailout. As a consequence, in crises policymakers often have little choice but to resort to broad public guarantees that maximize the disincentives to market discipline. The history of recent bank failures around the world shows that by itself a simple prohibition on public funding or a limitation to least, lesser or liquidation costs does not work. The paper argues that for cost controls to be effective regulatory authorities must have real alternatives to a bailout or liquidation. This requires balancing cost limitations or bans on public bailouts with a flexible system of bank resolution that allows continuation of key banking functions despite the collapse of the bank.
Keywords: prompt corrective action, banking resolutions, insolvency, moral hazard
JEL Classification: E5, E6, G18, G21
Suggested Citation: Suggested Citation