How large a problem is moral hazard caused by the Fed helping out troubled bank during financial crises? Pretty large, at least according to Jeffrey Lacker, President of the Federal Reserve Bank of Richmond.
One argument for central bank credit market activism rests on the notion that fragility is inherent in modern financial markets… Four decades of precedent [Fed and FDIC rescues of uninsured creditors] surely encouraged the belief that acute financial distress is likely to elicit some sort of rescue. Although this question is not yet settled, my view is that pre-crisis financial vulnerabilities were in large part induced by financial markets’ response to a long record of discretionary Federal Reserve interventions in credit markets.
Lacker heads one of the country’s 12 Federal Reserve districts, and thinks that the Fed is the problem. Unfortunately, he also thinks it is the solution.
One can appreciate how this interventionist tendency rose, though. When one is confronted with an instance of financial distress, an ex-post mindset makes it tempting to leave moral hazard problems for another day, to be dealt with after the crisis through tougher regulatory constraints on risk-taking.
If Lacker sees a “chicken or the egg” problem, he could appeal to the size of the problem. Richmond Fed economists estimated that at least 45% of financial sector liabilities were implicitly guaranteed by the government at the end of 1999. By the end of 2011 that figure rose to 57%. More than half of these guarantees were set by precedent, rather than explicit legislative solutions like deposit insurance.
Moral hazard is a problem, and every time it leads to a new chapter of crisis it gets worse. Ending Fed support for the financial sector today might cause some disruptions today, but at least it avoids a worse fate in the future.
(Cross posted at Mises Canada.)
