Overstating Moral Hazard: Lessons from Two Decades of Banking Crises

Abstract

Over the past two decades a variety of banking system rescue approaches have been used, including in the 1997 Asian financial crisis, the 2008 global financial crisis, and the 2010 European debt crisis. By analysing the resolution of these crises as well as the approach to addressing bad loans in the People’s Republic of China, this paper provides a new perspective on the common belief that bailouts are invariably harmful to public funds or excessively conducive to moral hazard. Depending on the form of bailout, bank restructuring, and fiscal backstop, resolutions can be an effective means to restore a banking system. This paper argues that in a systemic financial crisis, a combination of balance sheet restructuring and the use of asset management companies to deal with non-performing loans is often the best choice. However, a fully-fledged resolution that triggers the bail-in procedure remains the best approach for non-systemically important financial institution failures which take place outside of systemic crises, namely when the failure is idiosyncratic.

Keywords: Financial Crisis; Bank Rescues; Bailouts; Asset Management Companies; Moral Hazard

JEL Classification: G21, G28, G32, G33