To examine this, we must first understand that moral hazard, at its most basic level, is a problem of disincentives. This is similar to insurance and other aspects of human behavior where gains and losses are highly asymmetric.
Asymmetric gains and losses—where gains accrue to one group and losses are borne by another—naturally encourage excessive risk-taking. Findings typically include an emphasis on excessively large or short-term gains to achieve managerial goals or financial rewards. The resulting longer-term risks will hit hapless shareholders and affected communities once those risks materialize.
This is likely to change bank behavior in a number of ways, but not all involve excessive risk-taking. It is true that the advent of universal implicit deposit insurance could encourage banks to take on even more risk in order to generate financial returns. However, this is likely to be greatly constrained by even tighter oversight over a sector that is already one of the most heavily regulated sectors in a modern economy.
If the net result of increased regulation is reduced risk, then all else being equal, the likely returns for banks and the financial sector are likely to fall. Long-term lower bank yields essentially mean falling profitability. This would be perceived by investors as lower returns across the sector.
Alternatively, the cost of banking services will increase when banks have pricing power and can maintain profit margins despite the imposition of higher costs and lower returns due to reduced risk-taking.
If so, investors could continue to earn similar returns. However, the costs of safer banking are not going away, they are simply being passed on to the community in the form of higher banking service costs incurred by households and businesses.
Regulators have often referred to this as a trade-off: a safer banking sector brings significant benefits to society given the crucial functions that banks perform in terms of payments and financial intermediation. But a safer banking sector means a more profitable one for a given level of risk-taking. These profits are the costs that society pays on an ongoing basis to avoid the less frequent high costs associated with bank bailouts. It’s difficult to know where best to land on this compromise.
If the end result is less risk taking by banks and higher costs to society, what could this mean for investors going forward? One aspect relevant to this result is that moral hazard does not stop in the banking sector itself but, like most financial risks, is simply passed on from hand to hand.
The other hands in this case are governments, which are now on the hook to meet any needs that might arise to keep depositors sane, even in a more regulated world.
All other things being equal, this represents an uncertain off-balance sheet liability for governments. This has eroded government finances and resilience, which may well be marginal, but could give us higher long-term government bond yields as an indirect result of governments’ implicit support for their banking sector.
Where could this end? Governments typically behave in ways that maximize their chances of re-election and minimize voter backlash, consistent with the representative nature of governments in advanced economies.
For this reason, like many other current government expenditures, the fiscal cost of supporting the banking sector is often met by short-term borrowing. In times of strong future economic growth, such debts can be easily repaid and are unproblematic.
In less benign long-term, lower-growth scenarios, excessive leverage may mean that higher inflation is tolerated in order to reduce the real value of the debt burden.
Alternatively, when a government’s fiscal constraints become long-term binding, forced government spending cuts can lead to an economic downturn and a rise in unemployment.
None of these scenarios are attractive and all represent impacts that are marginal in nature, so the risks may be low. But all investors would be well served by recognizing the fundamental shift in the types of risk society has taken to protect and sustain the banking services we all depend on.
Tamar Hamlyn is a portfolio manager at Ardea Investment Management.
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