Do Banks Take Excessive Risks?

Economic Ideas from
Ed Dolan’s Econ Blog
Do Banks Take Excessive
Risks?
EI 131114
November 12, 2013

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Banks are essential but risky

 Banks provide essential services
 Accepting deposits
 Making loans
 Facilitating payments

 But banking is a risky business
 Risk from changes in interest rates,
exchange rates, or other market
prices
 Risk that loans will not be repaid
 Risk that liquidity will dry up in a
crisis

Dime Savings Bank of Brooklyn, NY

Economic Ideas 111314 from Ed Dolan’s Econ Blog

How much risk should banks accept?

 Banks should not try to avoid risk
 They face a trade-off: By accepting
more risk, they can earn a higher
return
 But how much risk should they
accept?


Do banks take excessive risks?

 Bank regulators fear that banks, left to
their own devices, will take risks that
are excessive from the point of view of
the economy as a whole
 Let’s look at some reasons why banks
might take excessive risks:
 Contagion effects
 Moral hazard
 Agency problems


Contagion effects
Contagion effects arise when the failure
of a bank causes harm to other
parties
 Failure of one bank can cause bank
runs as depositors take their money
from other banks
 Fear of more failures causes banks to
stop doing business with one
another, causing failures to spread
 When banks fail consumers and
nonfinancial businesses can’t get the
credit they need to operate normally

Moral Hazard

Moral hazard arises when someone who is
protected from loss fails to take
measures to avoid excessive risk
 The term originated in the insurance
business, where people who are insured
against loss fail to take measures to
minimize risk
 For example, people who have flood
insurance may build in areas that are
known to be at risk of flooding


Moral Hazard and Deposit Insurance
The purpose of deposit insurance
 During a bank run every depositor tries to
be first in line to withdraw funds
 Deposit insurance protects against bank
runs by promising to pay depositors even
if not first in line.

Deposit insurance and moral hazard
 Without deposit insurance, depositors
would be careful to put their money only
in banks that were operated safely
 With deposit insurance, this source of
discipline disappears—even the riskiest
banks can attract deposits

Deposit insurance can help prevent
bank runs like this one at Northern
Rock bank in England


How to avoid the moral hazard of deposit insurance
 Grant insurance only to small
depositors—use big depositors to
provide market discipline
 Rely on bondholders and other
uninsured creditors of banks to
restrain risk taking
 Apply risk based premiums – banks
with weak balance sheets must pay
more to join the deposit insurance
system.
 Make sure the deposit system is
adequately funded

Moral Hazard: Too Big to Fail
 If a bank is so large that its services
are essential to the rest of the
economy, the government may be
forced to rescue it when it is
threatened with failure
 If banks know they will be rescued,
they may take excessive risks—
another example of moral hazard
 The implicit guarantee gives the
largest banks a competitive
advantage over smaller banks
 Result: They grow even bigger


Ideas for limiting the TBTF problem

 Establish ―living wills‖ to guide the
liquidation of even the largest
banks
 Make sure managers and
shareholders bear their fair share
of losses when the bank fails
 Expose bondholders and other
unsecured creditors to ―haircuts‖ in
case of failure, that is, make sure
they also bear a share of losses

http://commons.wikimedia.org/wiki/File:Fat_Gator.jpg


Agency Problems: Fiduciary Duties of Managers

 As agents of shareholders,
financial managers have a
fiduciary duty to act in their
shareholders’ best interests
 They should take prudent risks
when there is a good chance of
a high return for shareholders. . .
 . . . but they should not put their
personal gain ahead of
shareholder interests, or gamble
with shareholders’ money

Alice and Jim Walton at 2011 Walmart
shareholders meeting


Gambling with your own money
When gambling with their own money,
many people think the best games
are ones like lotteries that
 lose most of the time, but not more
than they can afford
 don’t win often, but have a huge
payoff when they do win

 These are called positively skewed
risks
http://blogs.guardian.co.uk/money/lottery.jpg


Gambling with other people’s money
When gambling with other people’s
money, the best games . . .
 win some positive amount most of the
time
 rarely lose, but may have very big
losses when they do

 Once a big loss comes, the game
is over, but the gambler keeps
past winnings and someone else
bears the cost
 These are called negatively
skewed risks
http://www.stockmarketinvestinginfo.com/images/floorpic.jpg


Misaligned Incentives
 Executive compensation plans are often
poorly aligned with fiduciary duties toward
shareholders
 Bonuses for short-term performance
 Lack of ―clawback‖ provisions to
recapture past bonuses in case of
delayed losses
 ―Golden parachutes‖ that give large
severance payments to executives even
when their bad decisions cause large
losses

 Such bonus-based compensation plans
cause managers to seek strategies with
negatively skewed risks

“Golden parachutes” may tempt
executives to take risks that are not
in the interests of shareholders


Hypothetical Example of misaligned incentives
Assume a bonus plan that pays 0.1% of net profit each
quarter, with zero bonus in case of loss and no clawback

Strategy A
 5 quarters of $100 million profit
 5 quarters of $10 million loss
 10-quarter net for shareholders:
profit of $449.5 million
 10-quarter result for executive:
total bonuses of $500,000

Strategy B
 9 quarters of $200 million profit
 1 quarter of $2,000 million loss
 10-quarter net for shareholders:
loss of $201.8 million
 10-quarter result for executive:
total bonuses of $1.8 million
Negatively skewed strategy B has
higher payoff for the executive but
lower payoff for shareholders


Not just top managers

It is not only top managers who have
opportunities to gamble with other
people’s money
 Individual traders within banks
 Creditors of bankrupt firms, when
they expect bailouts to shift their
losses to taxpayers
 Bank depositors, when deposit
insurance shifts losses to taxpayers

UBS blamed trader Kweku
Adoboli for $2.3 billion in
losses . His defense was that
supervisors encouraged him
to ignore trading limits as
long as he was winning.




Why did Shareholders Let it Happen?
Why do shareholders condone compensation
policies that are not aligned with their
interests?
Some hypotheses:
 There is no misalignment—shareholders are
also biased toward excessive risks
 Technical error: Risk models do not reveal
the negative skew of strategic risks
 Bidding for management talent is subject to a
―winner’s curse‖ that leads to overly generous
compensation plans
 Moral hazard (expectation of bailout)
 Corporate governance—shareholders don’t
like compensation plans, but can’t do
anything about them

―Shocked Disbelief‖ .

“Those of us who have looked to the selfinterest of lending institutions to protect
shareholders’ equity are in a state of
shocked disbelief”

Alan Greenspan
Former Federal Reserve Chairman
Testimony before the House Committee on
Oversight and Governmental Reform
October 23, 2008


Do Banks Take Excessive Risks?

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