A very important speech today by Jeffrey Lacker, President of the Federal Reserve Bank of Richmond. Highlights include his views on the moral hazard created by central bank bailing out financial institutions:
“People often think of the moral hazard problem associated with a financial safety net as a “due diligence” problem. That is, investors in protected securities or lenders to protected institutions feel less of a need to assess and monitor the creditworthiness of their counterparties. This is a valid concern, but I think it construes moral hazard too narrowly in this setting. My discussion of the choice of leverage points to broader implications of central bank lending for the contractual structure of financial arrangements, not just on the monitoring of investment portfolios. In particular, the expectation of safety net support can weaken the incentive of counterparties to build provisions in to their financial contracts that reduce their susceptibility to (non-fundamental) runs. More broadly, an intermediary with access to the financial safety net has less incentive to manage their liquidity in a way that suitably minimizes the possibility of disorderly resolution of solvency problems.
Recent work by one of our Richmond Fed economists makes this point very clearly, using the standard model of banking theory. He and his New York Fed coauthor consider a setting in which if there is certainty that no government (or central bank) assistance will be forthcoming, then the banking contracts developed will include provisions that allow for suspensions of payment and these will prevent non-fundamental runs from occurring. On the other hand, if such central bank assistance is possible and a non-fundamental run actually does start, the government will choose to intervene in order to alleviate the ex post inefficiency associated with a run. But, knowing that this intervention is forthcoming, banks do not self-protect, and thus leave themselves more susceptible to runs. So peoples’ expectations regarding central bank policy choices in times of stress can affect the very robustness of the system.
This strikes me as a deeper form of moral hazard than what people usually have in mind. In times of financial crisis, the understandable central bank imperative is to alleviate the stress. But the expectations such actions engender could very well make future crises more likely. The classic time consistency problem is as relevant to central bank credit policy as it is to monetary policy.”
Entire speech: http://www.richmondfed.org/news_and_speeches/presidents_speeches/index.cfm/id=107