Banks, Bailouts, and Moral Hazard

This post is a response to a question asked of me in comments. Here’s the meat of the comment:

My main point is its the incentives. Bailouts create a bad incentive structure and trying to stop that is going to be costly. The longer it goes on the costlier it gets. Since we’ve already done this round of bailouts we have to wait for the next, and my claim/prediction/forecast/whatever is that the next round will be even bigger. And the fallout from not bailing out will be even larger than if we hadn’t done it now.

and, if I understand it properly, the question is what do I think?

I disagreed with the way the major banks were dealt with in 2008 and 2009. I thought it was costly, created moral hazard, and, worst of all, didn’t address the underlying problems of the banks. My preference was to do something analogous to what the Swedes did with their banks in the early 1990s and to what we did with S&Ls following the S&L crisis here in the late 1980s.

To refresh your memories as a result of misfeasance, malfeasance, and nonfeasance nearly 750 S&Ls and roughly 1,600 banks failed between roughly 1985 and 1991. Volumes have been written about the crisis, its aftermath, and its implications and I’m going to explore it much farther here. I only want to make two points about it:

• The facts of it should dispel any claims of our having any particular aversion to nationalizing banks.
• The scale of it should call into doubt any ideas that dealing with one very, very large bank or even several very, very large banks is impractical. If dissolving Citibank is more complex than dissolving 750 S&Ls, I cannot take arguments about increased returns to scale seriously.

I also think there are two distinct issues both of which are sometimes bundled together under the heading “moral hazard” but which are actually quite different. Moral hazard is properly considered the actions a particular course of actions incentivizes going forward. When you reward banks by giving them the largest payday loans in history to tide them over until their next binge, pay interest on reserves, and allow them to earn interest on Treasuries, you convince the managers of those banks that they have a property interest in the U. S. Treasury which will indemnify them against loss, come what may. When you bestow these gifts only on the largest banks while closing the smaller banks so their business can be gobbled up by larger ones, the ensuing consolidation increases the necessity of preserving future institutions whose failure would present systemic risk down the road. If a bank is too big to fail it is too big to exist.

The other issue is remediation. I can only explain what I mean by this by analogy. When a robber steals your property with a strong probability of apprehension, trial, incarceration, and return of his ill-gotten gains to its owners, it’s crime and punishment. When a robber steals your property with little or no likelihood of apprehension or punishment and even if apprehended were allowed to retain his loot, it’s a business plan. Following the S&L crisis there were roughly 10,000 criminal prosecutions. There have been fewer than a dozen following the 2008 financial crisis that dwarfs the S&L crisis in scale. This beggars credulity. And until very, very recently banks were continuing to pay bonuses. That’s a scandal and an outrage.

The best calculations of how large a financial sector we actually need is one about a third the present size. We have a very, very long way to go.

As an aside we are currently building about a third as many houses as we did in 2006. That’s another sector that needs to sink and the longer we try to prop it up the more painful the inevitable fall-out.