Northern Rock and moral hazard

People have been blethering on about the ‘moral hazard’ created by government deposit insurance for banks. Unfortunately, they’re idiots.

Deposit insurance *does not* encourage financial institutions’ shareholders to invest in risky assets, because it doesn’t prevent the shares from losing all their value when the risky assets go tits-up and the company goes bust. Since shareholder liability is limited to the value of their shares, there is no difference whatsoever for shareholders between a bank that goes bust losing its depositors all their money, and a bank that goes bust but whose depositors are baled out.

Providing deposit insurance simply means that the grannies who’re getting 5% a year on their life savings don’t need to become financial analysts to work out whether it’s safe to leave their money in (what they still think of as) the building society…

6 thoughts on “Northern Rock and moral hazard

  1. It does, however, encourage financial institutions’ depositors to invest in risky financial institutions.

    The Western Isles' council deserved to lose all the money it deposited with the Bank of Cocaine (heroin, actually, I think) & Corruption International. These days maybe the Government would have bailed them out. Thereby propagating idiocy.

    This probably doesn't apply at all to Northern Rock, but it does apply in some cases and in those cases the depositors too should swing in the wind.

  2. I'd tend to agree there.

    I guess the question is, how do you distinguish between grannies who've left their money in the building society which, without them noticing, has become a highly leveraged sub-prime investment fund, and jokers who think that depositing their money to drug-dealing crooks is a Good Idea if they get 7% interest instead of 5.%%…?

  3. John, an interesting view on the matter. However it is not the case that risky investments wont be made. It seems you are assuming that the people who run Norther Rock are the same people who own it.

    Moral Hazard in this case comes down to the principle agent problem. The people making the decisions for the bank are not the largest shareholders. They are simply some managers who by making the risky investments get the chance of a big bonus.

    They, unlike the shareholders, only have their jobs to lose. For them the risk is alot more worthwhile. And frankly if they did lose their jobs then they would probably expect a generous golden goodbye anyway.

  4. 100% agreed – it's your classic principal/agent problem. But the government's guarantee of compensation to *depositors* has no impact on the situation whatsoever, contra what various libertoonians were blethering about at the time.

  5. Interesting, personally I would argue that while the compensation to the depositers is in a way a seperate entity – but it does impact upon the willingness for the agents to take risks.

    If the government is willing to "restore confidence" in a bank so willingly then the management know there is always a saftey net. The fact that much of the depositors money is still in the hands of the bank will surely aid its recovery?

    And this recovery would not have happened if the government was not there to aid them. Do you not think that this might encourage other banks managements to take larger gambles knowing the Bank of England is protecting them?

    P.S – Thanks for your opinion, I'm currently writing a paper on the principle/agent problem here.

  6. Most of NR's deposits aren't in its hands, despite the government guarantees – IIRC 2/3 of deposits have now been withdrawn.

    And I don't think bosses are going to make the calculation "ok, this might bankrupt the company and wipe out our shareholders, but on the plus side at least the grannies won't lose their money". For a start, the bosses in question will certainly end up getting sacked even if the company survives.

    (if the government were bailing out shareholders, that would be a different story…)

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