The circumstances that make policy makers succumb to the “too big to fail” doctrine are similar. An important difference, however, is that a Federal Reserve chairman’s resolve to bail out banks actually increases the likelihood of disaster, since the implicit promise to intervene has a perverse influence on the banks’ willingness to take risk.
Worse, “too big to fail” creates a self-fulfilling prophecy: Shortsighted policy makers will always prefer the cost of a bailout to the cost of upsetting the market. As a consequence, the problem continues and expands. Anticipating government bailouts in case of emergency, lenders are willing to lend to large financial institutions very cheaply and without restrictions. The managers of these financial institutions find it attractive to borrow a lot and to take wildly risky gambles, because they can maximize their profits by doing so.
Unfortunately, the risky bets also maximize the probability that the government will have to intervene, as well as the cost to the government when it does.
Monday, 11 June 2012
Incentives matter: banking file
Anticipated, and actual, bailouts do cause moral hazard. This from Luigi Zingales at Bloomberg