Too Big to Fail, again? – Revisiting ‘Moral Hazard’ in 2023

Last month, in a letter to the cross-party Treasury Select Committee, Bank of England Governor Andrew Bailey wrote the following concerning the collapse and subsequent partial bailout of Silicon Valley Bank - “A blanket guarantee of all depositors is not costless,” Bailey said. “It reduces the risk sensitivity of a bank’s funding, could result in moral hazard, and any costs would ultimately need to be borne by the taxpayer”. The comments prompted me to revisit the topic of moral hazard and how it is manifesting itself in 2023.

For the uninitiated, moral hazard is defined as the tendency for individuals or institutions to take on more risk when they are protected from the consequences of their actions and is something which is applicable to all realms of the economy.

The last time moral hazard was really on the tips of tongues was during the financial crisis of 2008.

It is widely accepted that the origins of the crisis lay at the feet of financial institutions who were selling dubious sub-prime mortgages en masse to prospective homeowners in the mid-2000s. Where does moral hazard factor into this equation you ask? Well, this lies in the fact that the originators of these sub-prime mortgages were bundling these together and selling them off to investors, thereby spreading the risk of defaulting out amongst a much larger group of people and thus taking away the responsibility for these dubious packages. The ability of lenders to spread the risk, incentivising them to continue taking risky actions is a prime example of moral hazard.

As we know, the respective governments of both the UK and US eventually intervened, rescuing a series of banks through taxpayer funded bailouts and nationalisation schemes. These actions, though they are widely considered to have been successful in limiting the scope of the crisis, have contributed to a moral hazard of their own. Creating the perception that the fate of private banks is so intertwined with the fate of the broader economy that national governments will always prop them up in times of distress, thereby greatly limiting the risk associated with storing money in them.

Okay, that was 2008, let me now explain how this is all relevant to the current situation which is unfolding in front of us today.

The contemporary example of moral hazard that many are pointing to can be found in the US government's recent decision to fully bail out all of SVB’s depositors – not just those who fall under the FDIC insured rate of $250,000.

This is the decision that sparked Mr Bailey to comment last month and has drawn the ire of many in the industry including Standard Chartered Chief Bill Winters, who called the decision “the most wonderful example of moral hazard we’ve come across for quite a while” during a recent speech in Hong Kong.

The issue with handing out a blanket guarantee is two-fold.

It encourages financial institutions to both take further out-sized risks and also encourages them to offer much lower interest rates to savers across the board – another issue which has been capturing the media’s attention of late. If banks broadly speaking know that all their depositors will receive their money back and are thus not worried about the risk of ever losing their cash, they have far less of an incentive to offer higher, more competitive interest rates to savers that would otherwise be necessary to offset the risk depositors take by entrusting them with their money.

Now this is admittedly a gross over-simplification of the intricacies of banking, but it does nevertheless prove that the concept of moral hazard is alive and kicking in 2023. President Joe Biden has stressed that the SVB bailout will not amount to any expense for the US taxpayer, but this may not be the case the next time a big fish in the sector has to close its doors.