Over the last century, the world experienced multitudes of financial crises with different scales of complexity and severity. The frequency of severe banking crisis has increased dramatically in last two decades, Bordo et al. (2001). This escalating severity can be observed in recent episodes of financial turbulences, particularly, the 1997 Asian crisis, the S&L crisis in US, and the recent global financial crisis which started in 2007. Most economic downturns were related to financial panics. As a result, the governments in the world have become more concerned about financial stability. The World Bank revealed that government bailouts cost has reached 40% of GDP in many nations over the past two decades. Specifically, the saving and loan crisis in the US resulted in estimated losses of $180 billion, (3.2 percent of GDP), and the Asian crisis resulted in huge nonperforming loans; (approximately 25 percent of GDP in Japan) [1] .
Financial crises are reputed for their devastating impact on macroeconomic stability and economic growth. The recent global financial crisis, probably the worst of all financial storms since 1929, engendered economic disruptions of extreme severity, resulting in significant decline of economic growth throughout the world. (Figure 1).
Figure1:
Preventing financial crises is of crucial importance for Central Banks, Governments, and Financial Regulators who have committed themselves to building up a strong framework for effective banking regulation. According to Llewellyn (1999, p.9) the rational for banking regulation is justified by the critical needs The most renowned regulatory tools in government safety nets include prudential regulations (such as capital adequacy requirements, entry or competition restrictions, and so on), the deposit insurance scheme, and the Lender of Last Resort function of central banks.
SOURCES OF MORAL HARZARD IN THE BANKING SECTOR
ROLE OF DEPOSIT INSURANCE AND LENDER OF LAST RESORT
Generally, banks are prone to runs due to their essential asset transformation role; that is borrowing short" (by taking in demand deposits) and lending "long" (by making loans with longer maturities), (McCoy, 2006) and (Tosun and Aloko, 2010). So, banks balance sheets are inherently unstable due to term mismatches. Banks provide financial liquidity insurance to meet the different and incompatible needs of all types of economic agents. Having accepted liquid deposits from the public, as financial intermediaries, banks channel or reinvest these deposits in illiquid loans. In simple words, banks alter the long term illiquid assets with liquid assets collected from depositors in the form of certificates of deposits and checkable deposits.
In the asset transformation process, at least 80% of the bank's funds are invested in illiquid assets, (McCoy, 2006). Hence, only a small amount of cash money is generally available to cover withdrawals at specific times, (Horn, 2008). The banking system fragility is therefore extremely high. Banks operate on the principle of large numbers, as a result in the event of a run; the bank may not be able to liquidate immediately its assets to satisfy the immediate demand of depositors.
More importantly, bank runs can trigger immediate contagion and financial panic because; other depositors may start fearing the bankruptcy of their banks. If there is no deposit guarantees, the spread of rumors that a bank is on the edge of failure might causes depositors to panic on losing all their savings. The unpredicted sudden withdrawals ultimately lead to bank runs. In such situation, banks have to liquidate their assets; but liquidating the assets immediately might not be possible- even if it is, the price of assets will fall due to abrupt liquidation.
Bank runs and panics occur when depositors lose confidence. As a response to brutal banking panics which prevailed during the Great Depression, the US and many countries officially committed to guaranteeing deposits, generally through legislation by putting explicit or implicit deposit insurance in practice. This guarantee was an immediate response to resolve the problem of bank runs and the systemic economic consequences of financial contagion.
The main rational for this insurance was to strengthen depositors' security and confidence in banking system. The deposit insurance scheme assures depositors that they are protected, hence strengthens confidence even in turbulent financial distress. Using analytical liquidity insurance models, Diamond (1983, p.416) and Horn (2008) argued that deposit insurance (DI) plays a crucial role in preventing the phenomenon of bank runs and banking panic, hence very essential for financial stability. According to Ketcha Jr. (1999, p.224), DI help maintain stable economic growth by protecting the economy caused by bank runs.
Using time-series statistics from over 58 countries across the globe, Cull et al. (2005) empirically proved that a well designed and implemented DI scheme helps promote the development of the financial sector and economic growth through banking stability. In the 1930s, the US recorded over 9000 bank failures, most of which were caused by contagion runs, see: Figure 2.
Figure2:Source: www.calculatedriskblog.com
A careful examination of the frequency of bank runs before-and-after the adoption of deposit insurance in 1933 clearly prove that the insurance scheme was indeed effective in consolidating confidence, mitigating bank run problems, and fostering stability in the banking sector, Temzelides (1997), Aloko and Toson (2010).
The cost of banking crisis has deeper economic ramifications which surpass the massive cost of government bailouts to mitigate systemic risk, and central banks' quantitative easing to boost economic activity in bad times. The systemic nature of banking sector problems is the primary justification of extremely costly government intervention in the financial system. One of the most important regulatory tools to mitigate the problem of bank runs is the central bank's lender of last resort facility to solvent banks in times of financial distress. Sinclair (2001, p.8), By providing short term liquidity to solvent banks, the central bank therefore has the capability to promptly intervene to prevent the collapse of a giant bank; hence reduce the probability of banking instability by mitigating systemic disruptions on the entire economy.
In the United States, the too big to fail policy was adopted simply because the failure of one large financial firm can brutalize the whole financial system and lead to serious negative financial shocks with devastating macroeconomic implications. LLR and the deposit insurance scheme are therefore very critical in reducing the mounting cost of government bailouts, ensuring the stability of banking system, and all owing the financial system to operate smoothly, and promote economic growth, Demirguc-Kunt and Huizinga (2000). However, it has become a common knowledge that DI is an incontestable source of moral hazard. In the next section we will discuss the moral hazard implications of government safety nets and other multidimensional aspects of moral hazard problems in the banking sector.
THE MORAL HAZARD IMPLICATIONS OF GOVERNMENT SAFETY NETS
President Franklin Roosevelt was the first person who opposed the adoption of explicit deposit insurance in the United States in 1933; and he argued that the deposit insurance program would create unsound banking in the future, (McCoy, 2006). After five decades, his predictions became real with the eruption of series of financial crises in the 1980s in the US and across the globe. The IMF (1996) statistics revealed that over 130 nations suffered financial crisis in the 1980s. Roosevelt in 1933 had warned that the deposit insurance policy could create moral hazard incentives (McCoy 2006).
Moral hazard is the name given due to the increased risk taking temptation emerging from the insurance policy (Grubel, 1971). In this context, moral hazard is manifested in two ways; the explicit deposit insurance decreases incentives of shareholders and depositors to monitor banks' risk-taking. Secondly, this program stimulated banks' incentives to take more risks, because they will capture abnormal profits while they shift losses to the governments when they are in trouble. Prof. Lovett (1989) strongly argued that if modern nations and governments permit most banks to fail, the management of banks will be better disciplined in their risk management approaches, and they will also avoid poor asset- liability management.
In the presence of deposit insurance, a bank would consider increasing interest rate in a highly competitive environment to attract more depositors. In turn, in order to meet depositors' interest rate obligations, the bank will have an increased incentive to make risky loans to increase its profit and compensate depositors for taking on extra risk, (Demirguc-Kunt and Kane). Depositors knowing that their deposits are insured up to some limit by the governments; and they do not request a risk premium. Therefore, banks have higher incentives to take more risks, when deposits are insured, either by investing in riskier projects or elevating their leverage. This is to say that the government's loss exposure or taxpayers cost becomes higher in the presence of DI, ( Hovakimian, Kane and Laeven, 2003). As long as a bank's total expected returns from its asset portfolio exceed its explicit costs for deposit insurance premiums, moral hazard will continue to prevail, (Fischel, Rosenfield and Stillman, 1987).
Far from being a theoretical concern, moral hazard in explicit deposit insurance is significant and has real effect on banking stability, (McCoy, 2006). Throughout the world, it is empirically tested that explicit deposit insurance increased the likelihood of banking crises dramatically in the 1980s.
Moreover, when deposit insurance is combined with interest rate liberalization, moral hazard becomes even worse, because it allows banks to aggressively compete against each by raising interest rate on deposits, and constraining themselves to invest in extremely risk projects, hence putting at risk depositors money at the expense of taxpayers,( Demirguc-Kunt and Detragiache, 2000). In addition, since all the deposits are secured, depositors find no incentive in monitoring their bank's risk taking, therefore tolerating risk-loving managements to engage in excessive risky investments to uplift returns.
POLICY OF CREDIT CEILING AND MORAL HAZARD
Standard thinking about the need of the financial liberalization and interest rate describe policies that alter and distort domestic capital markets through high reserve requirements and interest rates ceilings. In a financially repressed economy, real lending and deposit rates are mostly negative, with adverse implications for the financial system's development and for investment and savings generally. Therefore, the purpose of the standard approach by this liberalization is to eliminate credit control as well as to achieve positive real interest rates on bank loans and deposits.
Financial and initial economic conditions throughout many countries significantly varied and influenced subsequent performance. However, the policies of interest rate, the banking system's prudential supervision and banking regulations shared common characteristics to the relatively successful cases of financial liberalization. Countries, specifically, avoided the adverse outcome of large financial liberalization- financial institutions' bankruptcies, sharp rises in interest rates. By doing so, they characterized stable macroeconomic conditions (Villanueva and Mirakhor, 1990).
In the earlier period, low interest rates was one of the two consequences of government interventions with credit rationing, and "removal of controls" was able to lead to a more efficient, dynamic, and healthy financial system (Villanueva and Mirakhor, 1990). According to Villanueva and Mirakhor (1990), in most countries, banks were not allowed to pay explicit interest on demand deposits; therefore, the ceiling on deposit interest rates has been abolished since 1980s.
However, the current literature has substantially made it clear to understand how bank credit markets operate, particularly how asymmetric information between borrowers and lenders might lead to efficient optimal interest rates, when the interest rate ceilings is absent. It is also understood that inadequate bank supervision generally ends with an immediate rise in real interest rate with risky levels (Villanueva and Mirakhor, 1990).
Additionally, one of the main reasons for the ceiling (entitled as "public interest") is the need for reducing or buffering the competition among banks (Eichberger and Harper, 1989, p.19). Banks are forced to pay higher interest rate for the deposits and this resulted in the temptation of banks to invest in riskier projects to offset the interest cost. As a consequence, banks became riskier, increasing the proliferation of banking crises.
McKinnon (1986) suggested that it is desirable for the government to impose some ceiling on standard deposits and loan interest rates to prevent moral hazard in the banking sector because banks have intensives to provide risky loans at high interest rates, and expect that deposit insurance policy will cover the large losses.
2.4.4 FINANCIAL INNOVATION AND MORAL HAZARD (FINANCIAL CRISIS 08)
In the United States, securitization is one of the most important innovations that promoted the growth of mortgage credit supply at aggregate level, Shin (2009). During the housing boom that preceded the subprime crash in 2007, banks unwisely exploited innovations in securitization to increase returns by leveraging their capital to unsustainable level, without considering systemic risk. In the securitization mechanism, banks massively originated mortgages that they assembled together in CDOs, marketed to investors to finance their loans. The originate-to-distribute process of shifting risk off-balance sheets and transferring them to external investors reduced banks' incentives to properly screen borrowers because they knew they would not bear full cost of bad loans in the worst scenarios.
In addition, credit rating agencies accentuated this moral risk by mispricing CDOs (Junk bonds rated AAA). "Multi-layered agency problems" and distorted incentives in securitization chain eroded the quality of lending standards, and a huge amount of credit was cheaply granted to unworthy households, (Shin 2009, p.312). Central bank's monetary excesses resulted in abundant liquidity that in turn fueled the housing bubble, Blundell-Wignall et al (2008). Banking supervision failed to assess and control all these risks. Banks took advantage of profit opportunities that arose during the housing boom to expand their mortgage holdings regardless of concentrations risk and potential risk of defaults in the event of a bursting of the bubble. This tendency of banks to abuse innovations in structured finance, and take reckless risks while expecting the government to bear the cost of their wrong actions, is a critical aspect of moral hazard in the banking sector. Traders massively invested in CDSs bets, "Subsidized Risk-Taking: Heads I Win, Tails You Lose"; leading to strong interconnections and counterparty risk between banks and other financial markets participants Dowd (2009, p.142). Over $500 billion of CDOs and 60 trillion Webs of CDSs derivatives were outstanding in 07/08, Dowd (2009).
Historical example of government interventions that created moral hazard in the US include the Federal Reserve bailout plan to contain systemic risk when Long Term Capital Management was in trouble in 1998; Bear Stern was also bailed out in 2008 at the expense of moral hazard, Alm, et al. (2008). The catastrophic collapse of Lehman in Sep 2008 amplified the cost of government bailouts during the global financial crisis; the US devoted over $700Bn in the troubled asset relief program. The central banks around the globe enormously injected liquidity in the financial system to restore stability and revive economic activity, see: Figure 3.
Figure 3:
