The Moral Hazard Paradox of Financial Safety Nets

Abstract

Moral hazard plays a central role in almost every narrative of the recent financial crisis: government’s implicit guarantees led to excessive risk-taking, and when the guarantees turned explicit, it exacerbated moral hazard going forward. The moral hazard narrative of crisis causes and effects motivated key reform efforts, including the statutory elimination of authorities regulators used to guarantee trillions of dollars of private debt in an effort to halt widespread panic in late 2008. Some argue that the elimination of these broad guarantee authorities was a mistake, but even these critics acknowledge that the moral hazard costs of guarantees are significant.

This Article argues that the absence of broad guarantee authorities could, counterintuitively, exacerbate moral hazard in the current U.S. financial system. Broad guarantee authorities can be seen as a “strong” tool for stopping panics. Stripped of this strong tool, regulators nevertheless retain a number of weaker tools that, while unequal to containing a full-blown panic, might prevent one from starting in the first place through targeted bailouts of specific firms or their creditors. Lacking a strong panic-prevention tool, regulators are likelier to err on the side of caution in saving a weak firm even when the firm’s failure might not have sparked a panic. It is possible, therefore, that weak firms are more likely, rather than less likely, to be bailed out in the current system.

If guarantee powers make bailouts less likely under some conditions, their impact on moral hazard – which arises from bailout expectations – is ambiguous. This strengthens the case for reestablishing broad guarantee authorities.

Keywords: financial crisis, financial regulation, moral hazard, banking regulation, shadow banks, financial panic