Moral Hazard: The Long-Lasting Legacy of Bailouts

The U.S. government appears to be committed to supporting any large bank that gets into trouble. A bailout environment distorts risk assessments. Debt capital flows more readily to large institutions, even inefficient ones, than to small ones. This article proposes reforms to the U.S. financial system. A change in incentives is needed. Phasing out the deductibility of interest on all business tax returns would reduce the incentive for leverage. Another reform would require all banks to issue 10-year subordinated notes, which would provide a large capital cushion. Banks would have to go to market every year to replace maturing subordinated debt, which would greatly enhance market discipline. Listen to a presentation by the author based on this article.The federal government appears to be committed to supporting any large bank that gets into trouble. A bailout environment distorts market risk assessments. Debt capital flows more readily to large institutions, even inefficient ones, than to small ones. Because of the moral hazard created by the high probability of a government bailout of a failing large bank, capital is misallocated and banks are encouraged to take on excessive risk.The current bailout regime is unacceptable politically because risks are socialized and gains are private. Taxpayers are understandably and appropriately angry that although they assume the risk of failed corporate policies, executive compensation is often huge. The public’s anger over this situation is leading to inefficient and ultimately ineffective regulatory policies, such as constraints on executive compensation.Tougher regulations cannot fix “too big to fail.” For one thing, regulators are not omniscient. They missed the subprime mortgage developments that created the 2007−09 financial crisis, just as they missed the Latin American debt accumulation in the 1970s that almost sank several large money-center banks in the 1980s. Regulators are subject to political pressure, as shown by the savings and loan problems that emerged in the 1970s and 1980s. Even in the midst of the current financial crisis, the U.S. Congress pressured the Financial Accounting Standards Board to modify fair-value accounting.What is needed is a change in incentives, not more regulation. Investment and commercial banks entered the financial crisis with too little capital, motivated in part by the deductibility of interest, but not dividends, on corporate tax returns. Phasing out the deductibility of interest on all business tax returns would reduce the incentive for leverage. A revenue-neutral reform would reduce the statutory corporate tax rate from 35 percent to about 15 percent.Another reform would require all banks to issue 10-year subordinated notes equal to 10 percent of total liabilities. Moral hazard cannot be controlled without putting some creditors at risk. But the creditors at risk must own long-term bonds; short-maturity debt can run by not being rolled over when due, which makes the financial system vulnerable to a liquidity crisis. Long-term subordinated notes would provide a larger capital cushion, and banks would have to go to market every year to replace maturing subordinated debt, which would greatly enhance market discipline. A bank that could not replace maturing subordinated debt would have to shrink. For example, with 10-year notes equal to 10 percent of liabilities, a bank unable to sell new subordinated debt would have to shrink by 10 percent to live within its remaining subordinated debt. Contracting a bank by 10 percent a year is perfectly feasible. Any bank restructuring should be managed by the bank and not by regulators.Note: This article is based on a speech that the author gave at the CFA Institute Annual Conference in April 2009. He was president and CEO of the Federal Reserve Bank of St. Louis from March 1998 to March 2008.