Moral Hazard is widely misunderstood - by Arnold Kling
I’ve seen a lot of commentary, by public officials and pundits, that because shareholders lost everything in the Silicon Valley bank bailout, there is no problem of moral hazard. This is Baloney Sandwich.
Moral hazard in banking is the incentive of owners to take large gambles with depositors’ money. That incentive exists even if the owners lose everything in a bailout.
Suppose that my bank is no longer profitable. Perhaps some loans I made in the past went sour. Or maybe my costs are high because I am a bad manager.
At this point, if I obtain some more funds from depositors , I can go to Las Vegas and hope I get lucky. If I lose, I have not lost anything, because my bank was not profitable. If I win, I can get rich. In fact, I will be desperate enough to try this that I will pay an above-market rate to get deposits. And depositors will be content, knowing that the government is providing a guarantee.
Note that in the process of bidding for deposits, my unprofitable bank pulls money away from profitable banks, who would rather not pay above-market rates. That is another adverse effect of moral hazard that no one seem to understand.
