Former FED chairman Paul Volcker once said that “about every ten years we have the greatest crisis in 50 years”. 2023, it seems, will not see a global financial meltdown –a welcome prospect considering the year’s already long list of crises. However, bankers and regulators temporarily braced themselves back in March when Silicon Valley Bank threatened to close its doors. The saga of this California bank sent shockwaves through the banking industry and brought the questions of financial regulation back into the spotlight. Much as in 2007/2008, the government stepped in to provide a bailout to prevent panic from spreading through the banking system. In the case of SVB, the bailout was controversially provided to a largely unregulated bank and its significant number of uninsured deposits[1]. In this post, we ask if there is anything morally problematic with the financial industry’s risk-taking behaviour in the expectation of a bailout. Revisiting Claassen (2021; 2020) and Hale (2009) we ask: what is so moral about moral hazard in banking?
One could argue that moral hazard, namely the tendency to take riskier actions as a result of being insured, lacks substantial moral significance and rather reflects a mere economic phenomenon. Intuitively, we take up car insurance to reduce the cost of future accidents, which buys us peace of mind we could not have if we had to pay in full each time we scratch the bumper. Insurance in this sense enables us to drive a bit faster and without worries and, crucially, this is the very point of paying for it. Risk-taking is an intrinsic element of insurance, a beneficial and necessary feature of it, not a bug. Granted, there may still be morally problematic behaviors under insurance, such as lying or committing fraud, but these acts would be immoral on other grounds unrelated to the insurance relationship.
In principle, this line of reasoning can be extended to the realm of bank bailouts. States would fulfil the role of insurer and banks that of the insuree. The bailout would be an insurance claim, paid out when increased risk taking leads to an unanticipated accident. Without some peace of mind it would be impossible for credit institutions to finance useful, yet risky projects, since depositors, who are typically risk-averse, would immediately pull out their savings at the first sign of economic turmoil. When they do so and panic spreads, otherwise solvent credit institutions can go bankrupt, together with the productive businesses they were financing before. In other terms, the existence of an insurer of last resort grants everyone, depositors and bank managers, the peace of mind they need to finance worthy investments. In turn, or so the argument goes, there is nothing morally problematic with banks’ risk-taking behaviour nor in bank’s bailouts for the former is an intrinsic and necessary element of the latter, rather than some form of cheating.
Can we let Silicon Valley Bank’s managers off the hook so easily though? Are all levels of risk-taking morally justifiable provided one is insured? Continuing the analogy with cars, critics would say that it is unreasonable to put on the same moral plane the reckless driver and the driver who is confident enough to drive at the speed limit, even though both benefit from the peace of mind offered by insurance. Insurance is not some morality-free space. When I purchase car insurance my level of risk-taking will affect the costs of insurance paid by other drivers in the insurance pool, since we are all socialising the risks of driving via the insurance company. In turn, there seems to be some duty that insurees have towards each other to target some optimal level of risk. This level would balance the benefits of insurance to individual banks with the collective costs to the banking industry of funding this scheme. Banks’ risk-taking behaviour would thus seem to be morally problematic if (and only if) it surpassed this optimal level. A question still remains though: can we be sure though that the optimal risk level for the banking industry will be equally optimal for society as a whole?
Ideally, the relationship between banks and citizens or states would work like this: citizens, through their states, target some risk level, and banks, in turn, operate within those boundaries. In practice though, forcing banks to target this level of risk is particularly hard to do, as epitomized by the Silicon Valley Bank debacle. Back in 2018, this institution actively lobbied for the partial deregulation of medium-sized banks[2], thus undermining the very conditions for responsible and moral risk-taking. Indeed, this partial deregulation is an erosion of the social contract between banks and the rest of society, as citizens lose the regulatory oversight and capability needed to steer banks toward the socially optimal and collectively agreed level of risk.
The consequences of this erosion of the social contract do not simply lead to immoral risk-taking, but to the disregard for citizens’ interests and status as decision-makers. Indeed, at the core of this ‘immoral moral-hazard’ lies a form of domination, namely the subjection of society to the power of the banking industry. As unregulated banks become too-big-to-fail they force the rest of society to foot the bill when their risky investments do not go as planned. Moral hazard does not need to be immoral, provided the insurance relationship is meaningfully under the control of those who will bear its costs. When instead, as in the Silicon Valley Bank case, the main levers of control are weakened, financial institutions can leverage their size and position to force the state to do what ex-ante was not in citizens’ interest.
In conclusion, the 2023 Silicon Valley Bank fiasco reminds us of the risks for society of losing control over the regulation of credit. This control is ultimately what allows societies to uphold the social contract with banks and distinguish normatively problematic moral hazard from justified risk-taking.
Notes:
[1] More than 85% of SVB deposits were uninsured; a controversial reality in light of the large bailout that may have created undesirable moral hazard problems in the future. As pointed out by former Fed regulator, Daniel Tarello, “[...] uninsured depositors are now going to believe, ironically, that if they have an uninsured deposit in a bank with lots of uninsured deposits, they’re pretty likely to be bailed out. Under our current system, that’s not the kind of incentive you want big depositors to have.” [2] SVB, among other medium-sized banks, lobbied for the exemption from the 2010 Dodd Frank Act where “too big to fail” banks were put subject to enhanced federal oversight. Within this act, banks with consolidated assets of $50 billion or more were labeled “too big to fail”. In 2018, the lobby successfully lead to an increased threshold of $250 billion, satisfying the wishes of the chief executive officer of SVB who actively urged Congress to lower the threshold.
Works Cited:
Claassen, R. (2015). Financial crisis and the ethics of moral hazard. Social Theory and Practice, 527-551.
Claassen, R. (2021), The Ethics of Moral Hazard Revisited. In Flores Zendejas, J., Gaillard, N., & Michalek, R. (2021). Moral Hazard: A Financial, Legal, and Economic Perspective.
Hale, B. (2009). What's so moral about the moral hazard?. Public Affairs Quarterly
Claassen, R. (2015). Financial crisis and the ethics of moral hazard. Social Theory and Practice, 527-551.