Tag Archives: Moral hazard

Could the Fed have Rescued Lehman Brothers?

In a paper, Larry Ball argues that

inadequate collateral and lack of legal authority were not the reasons that the Fed let Lehman fail. …

… the primary decision maker was Treasury Secretary Henry Paulson–even though he had no legal authority over the Fed’s lending decisions. … evidence supports the common theory that Paulson was influenced by the strong political opposition to financial rescues. … Another factor is that both Paulson and Fed officials, although worried about the effects of a Lehman failure, did not fully anticipate the damage that it would cause.

James Stewart comments in the New York Times.

Narrow Banking: History and Merits

George Pennacchi discusses narrow banking in an article in the Annual Review of Financial Economics. He concludes as follows:

During the nineteenth century, US banks were more narrow than they are today, and the narrowest (e.g., those under the Louisiana Banking Act of 1842) appeared resistant to panics. Common modern-banking practices, such as maturity transformation and explicit loan commitments, arose only after the creation of the Federal Reserve and the FDIC.

… There appears to be little or no benefits available from traditional banks that could not be obtained in a carefully designed narrow bank financial system. Most importantly, a narrow-banking system could have huge advantages in containing moral hazard and reducing the overall risk and required regulation of the financial system.

In contrast, the reaction by US regulators to the recent financial crisis was to expand the government’s safety net by raising deposit insurance limits and by giving more financial firms access to insured deposits. Expanding, rather than narrowing, the activities that are funded with insured deposits is justified if one believes that regulation can contain moral hazard when firms have many, complex risk-taking opportunities. Unfortunately, this belief appears dubious if one recognizes that regulators face political and information constraints.

In my view, there is a need for research that considers the optimal design of a financial system when a government regulator is limited in its ability to assess risk. … Research needs to better identify those financial services where government support would produce a net social benefit. Services such as maturity transformation and liquidity insurance may not deserve costly government guarantees. Finally, should further research support the general concept of narrow banking, there are still open questions regarding the specific features of these banks. In particular, how narrow should be these banks’ assets and should their liabilities should be deposits or equity shares (at fixed or floating NAVs) are questions that need better answers.

“Mistakes Made and Lessons (Being) Learned”

In the seventh chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Peter Fisher argues that the Fed’s mandate should be reviewed:

  • The Fed did not address leverage early enough. In the future, monetary policy should weigh financial stability objectives more strongly—at the cost of employment and inflation objectives.
  • Moral hazard should be addressed before, not during the crisis.
  • “Since the end of the financial crisis, the Fed is making the mistake of conceiving of its mandate over too short—and too narrow—a horizon. This permits the Fed to avoid articulating the difficult intertemporal trade-offs that it is making.”
  • The Fed’s mandate is not crystal clear and has been interpreted differently over the years. In light of the new experiences, it should be clarified or adjusted.