The moral hazard of bailouts
There is so much going on with your banks (again) that I have to say something about it. Probably there has been less commentary on whether Elon Musk will name his next offspring ‘ Q’ than about Silicon Valley Bank (SVB) and Credit Suisse First Boston (CSFB) rescue. The point is the topic is widely written about, but I want to say something that has probably not been said/written with ample clarity.
I spoke of bank runs in one of my pieces where I explained the difference between solvency risk and liquidity risk (‘Lessons from crypto debacle’, January 1).
The issue I highlighted was the business model that banks follow (converting standalone credit risk for depositors into a broader market risk which is manageable and accepted) has no protection against a scenario where ‘enough’ depositors ask back their deposits at the same time.
Banks are sitting ducks if/when that happens. It doesn’t matter if it’s a liquidity/ operational risk (SVB) or credit risk (remember 2008) or interest rate risk (again SVB), once the news is out it will turn into solvency risk.
The only thing that can save the bank after such bad news is a bigger institution with deeper pockets to assume those deposits. In this piece I am going to talk about the rescue process of such a banking business model and how wonderful it is.
Assume you have $10 and you can raise $10 from nine more people you know by offering 10% return ($1). But if you tell them you will be going straight to a casino with the $100 (10% yours and rest from others) and make one bet of $100 on red on the roulette table, they will freak out and say “no way José”.
But then you find an insurer who would insure up to $10 losses for all your creditors. You go back to your perspective creditors and this time tell them you have insured them fully. Lo behold, they all give you $10 each, as the maximum return they can get from anywhere else is 2%/annum and you offered them 10%/day.
Their pay off is $11 or $10 tomorrow, with expected returns of $0.5 (it’s actually slightly lower than $0.5 as probability of red/black is slightly lower than 50%, but let’s not get into that).
Let’s assume you have to pay $5 to the insurer, and miscellaneous costs (driving to the casino, depreciation on your car, opportunity cost of not being able to come up with even more productive business ideas whilst you have to take time to bet on the roulette table, etc.) is $3.
So your payoff is $101 or $0, with expected return of $50.5 (on a capital of $18). Congratulations, you have invented a money machine, and all you need now is that insurer.
Now in the story, replace yourself with ‘banks’, your creditors with ‘bank depositors’ and insurer with ‘you – the taxpayer’.
It surely is a ‘wonderful life’ (reference the 1946 classic It’s a Wonderful Life – and yes, there are bank runs there). I usually keep the punchline for the end but this one fits in nicely after the story.
The moral hazard I am pointing at was highlighted after the financial crisis in 2008 when major banks were bailed out. That gave rise to some serious pushback from the regulators/politicians/public. Some questionable asset classes like cryptos, and some banking regulations (Dodd Frank) happened after that.
But all that turns out to be futile for two reasons:
Massive amount of liquidity; and
Inability of monetary policy to have any sustainable inflation and hence even more provision of liquidity.
SVB had to be bailed out because they were invested in the safest assets in the world (US Treasury) – see the irony in that statement.
In the story above, would you blame the investors for taking on an investment opportunity or the insurer who insures the dubious plan? It’s questionable whether all deposit holders should be bailed out. Should CSFB equity holders have been bailed out whilst junior debt holders were bailed in?
There is no easy answer to any of these questions.
Maybe I can talk about it in another piece but the question we need to ask is: why can’t our regulators/politicians get the right amount of regulation so that they don’t stifle the credit cycle (and eventually growth) and not keep bailing out gamblers in the banking industry?
Wish I had an answer.
Somnath Banerjee is head of Investment Management at Curmi and Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
“Why can’t our regulators/ politicians get the right amount of regulation, so they don’t stifle the credit cycle and not keep bailing out gamblers in the banking industry?