Some Fed officials are very concerned that the new facilities put into place to provide liquidity to investment banking firms will promote moral hazard and should be shut down as soon as possible. Such facilities would be unnecessary of course, if bank regulators and supervisors were more effective in preventing financial institutions from excessive risk taking. In truth, providing adequate oversight is very difficult. Financial instruments and practices change far more quickly than regulators are able to adapt to them. The market supervises itself reasonably well most of the time, when counterparty risk is fairly transparent. Still, it is certain that bouts of excessive risk-taking will occur, so mechanisms must be put into place to fix the problems as they arise, or to pick up the pieces after they fail.
Moral hazard is the term that describes excessive risk taking by market players, because they think someone will bail them out, giving them a one-way bet. People who build homes on the shore line in the path of hurricanes should not be permitted to buy cheap storm insurance. To discourage excessive risk taking, these players must be allowed to fail. Otherwise, they set a bad example, by encouraging others to engage in equally reckless behavior and society bears the cost of bailing them out. Former Fed Chairman Paul Volcker and current Fed Bank President Jeffrey Lacker share the view that the Fed's decision to offer a discount window facility to investment banking firms will encourage excessive risk taking, because they now have a means to obtain liquidity during periods of market stress. The Volcker-Lacker view is troublesome, because they are focusing on just one side of the moral hazard issue.
The Fed acted wisely, in my opinion, to contain the potential damage that could have occurred if Bear had been allowed to default. The entire global financial system would have placed under extreme stress, had the Fed allowed Bear Stearns to fail. Allowing such failures would have engulfed others who did not knowingly engage in risky behavior and might damage the entire financial system, which is also a very costly burden on society. Moreover, the shareholders of Bear Stearns certainly do not think they were bailed out at $10 per share, although a better case can be made that the bondholders and other creditors of Bear were bailed out.
Too often, regulators just don't adequately oversee risk taking and fail to take the steps necessary to prevent a very significant financial failure with severe consequences. We readily observe the U.S. banking system has been at risk every time a major financial failure occurred almost anywhere in the world. Commercial banks were badly overexposed to emerging market credit risks in the 1980s, to domestic commercial real estate lending in the late 1980s, to Asian credits in the mid-1990s, and to residential mortgages most recently. Previous Fed Chairman Alan Greenspan actually encouraged households to take on floating rate mortgages while he held that office. However, this meant that households and their bank lenders were taking on more risk that would become evident during any period in which interest rates might rise sharply. And commercial banks may be our most highly regulated and supervised financial institutions!
While regulators are supposed to be trying to prevent financial blowups, our supervisory efforts are clearly lacking. Major blowups occur with painful frequency despite the extensive regulatory and supervisory functions of several government institutions. As a result, it is critical that we also have facilities in place to minimize the damage that occurs when future financial mishaps next occur. Experience suggests rather strongly that more such failures will occur from time to time, even if the nature of each blowup differs from prior ones. The art of running a regulatory system is to balance the cost and risks of moral hazard on the one hand with the high cost of failures on the other. Download this article in PDF Format
About Advisors Capital Management, LLC
Advisors Capital Management, LLC (ACM) is a provider of managed portfolios and financial services for industry professionals and their clients. As investment strategist, Dr. Lieberman oversees the company's "Portfolio Partners" investment program. Additionally, he provides guidance to the ACM Wealth Coordinators who integrate the work of financial advisors, financial planning, tax, estate and portfolio management professionals to build, protect, and maintain clients' wealth. Although the information included in this report has been obtained from sources Advisors Capital Management, LLC believes to be reliable; we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
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