Bank bailouts create moral hazards, says Weber

Weber, who is a member of the European Central Bank’s (ECB) governing council and is also the man hotly tipped to succeed current ECB President Jean-Claude Trichet upon his retirement, was speaking in Dublin yesterday.

The moral hazard problem
In his speech, Weber pointed out the need for global governments to tackle the problem of moral hazard created by bailing out banks.

He highlighted that the costs of stabilising the financial system are not being borne by those who caused the crisis but by taxpayers. “This uneven distribution of costs is certainly not right morally, and it is also fraught with problems from a financial-stability viewpoint. The fact that it is not the originators of the crisis that have to foot the bill induces moral hazard and this, in turn, promotes risk-prone behaviour and increases the likelihood of future crises,” he said.

Unfavourable consequences from Volcker rule
Weber also pointed out a number of shortcomings with the Volcker rule proposed by US President Barack Obama, which would bar banks completely from certain forms of risk-taking, such as investing in or sponsoring hedge funds or private equity funds, and would also place a cap on their size.

He said the US plan would represent a “very far-reaching market intervention” and might have “unintended and unfavourable” consequences, such as having undesirable effects on the transmission of monetary policy.

He also said another problem with the Obama plan is that it would most likely not apply to hedge funds or investment banks, despite the fact that failures of such investment vehicles could also lead to major financial market problems, such as that caused by the failure of Lehman Brothers in 2008.

European Stabilisation Fund doesn’t address moral hazards
Turning to the idea of creating a European Stabilisation Fund for bailing out banks that get into trouble, Weber said such a fund would not solve the moral hazard problem.

“As the fund would act as lender of next-to-last resort for failing banks (the government would still have to step in if the fund’s resources were exhausted in a crisis), the problem would merely be shifted from the level of government to the level of the fund. The banks, in fact, would still have an incentive to take on too much risk, while relying on the fund to cover potential losses,” he said.

“In the case of a European fund, the moral hazard problem might even be amplified, since costs that would normally occur at the national level could be shifted, at least partially, to the supranational level. A systemic crisis might even provoke a rat race among national governments for the fund’s limited resources,” he added.

Instead, Weber pointed to the reform of the rules governing the amount of capital banks must hold within the Basel II framework as the “most comprehensive” proposal to reduce the likelihood of individual bank failures.

This idea is based on the assumption that, for individual banks, higher capital requirements should be their main buffer against any losses incurred.