Moral Hazard Incentives Research Articles

Moral Hazard Incentives under Formal Insurance and Informal Insurance: Evidence from a Framed Field Experiment

Abstract This paper explores moral hazard incentives associated with formal and informal insurance. We develop a theoretical model of risky effort that incorporates formal insurance and informal risk sharing, and test model predictions through a real-effort experiment with smallholder farmers in rural Uganda. Consistent with the theory, we find evidence of moral hazard under informal insurance. We, however, do not find evidence of moral hazard under formal insurance in our experiment. Experiencing a bad outcome, however, makes the risk in production more salient to farmers, and they increase their insurance coverage. These results suggest there may be some space for expanding indemnity-based insurance to smallholder farmers through awareness programmes.

Research on Credit Default Swaps Pricing Considering Moral Hazard Incentive under Reduce-Form Model

Research on Credit Default Swaps Pricing Considering Moral Hazard Incentive under Reduce-Form Model

Critical condition for deposit insurance to partially or fully substitute for raising capital under cyclical economic environment

<p><big>Regulation of financial institutions has two key purposes: Solvency (prudential regulation) and consumer protection. Prudential regulation is implemented mainly by capital requirements, but governments also provide insurance for customer deposits, as a backup tool. In this article, we discuss the critical conditions for deposit insurance and capitalization to act as substitutes for each other, under cyclical economic environment. We make two assumptions. The first one is that deposit insurance is fairly priced and there is no moral hazard. The second one is that insurance creates incentives for moral hazard among insured banks, resulting in increased risk taking. We also discuss the critical conditions for deposit insurance and capitalization to be complementary under different proportions of deposit insurance.</big></p>

Wholesale funding and liquidity creation

We examine the relationship between wholesale funding and liquidity creation using a sample of 825 banks in 84 countries during the post-crisis period of 2010–2020. We find that asset-side liquidity creation is consistently negatively associated with short-term wholesale funding, but not with long-term wholesale funding. Our results suggest that the relationship of short-term wholesale funding with asset-side liquidity creation is significantly driven by a negative relationship with illiquid lending. Moreover, our results show that the negative relationship between wholesale funding and liquidity creation is positively moderated by asset risk, suggesting the presence of moral hazard incentives. Our results are robust to a series of tests and have important implications for bank liquidity regulation.

Are the Largest Banking Organizations Operationally More Risky?

AbstractThis study demonstrates that, among large U.S. bank holding companies (BHCs), the largest ones are exposed to more operational risk. Specifically, they have higher operational losses per dollar of total assets, a result largely driven by the BHCs' failure to meet professional obligations to clients and/or faulty product design. Operational risk at the largest institutions is also found to: (i) be persistent, (ii) have a countercyclical component, and (iii) materialize through more frequent tail risk events. We illustrate three plausible channels linking BHC size and operational risk—institutional complexity, moral hazard incentives arising from “too‐big‐to‐fail,” and innovation.

Eurobonds: Three Lessons from China’s “Debt Centralization/Decentralization” Experience

Abstract Eurobonds, dubbed as Coronabonds in the context of the current coronavirus crisis, are being hotly debated among the euro area member states amid the COVID-19 pandemic. The debate is in many ways a retread of the euro area sovereign debt crisis of 2011–2012. As China’s “debt centralization/decentralization” experience is comparable with the introduction of Eurobonds in the European Union (EU) in terms of institutional mechanism design, we review our previous series of studies of China’s “debt centralization/decentralization” experience to shed some light on the Eurobonds debate. We obtain three key lessons. First, the introduction of Eurobonds in EU is likely to soften the budget constraint of the governments of the euro area member states. Second, it is also likely to strengthen the moral hazard incentives of the governments of the euro area member states to intentionally overstate their budget problems. Finally, the magnitudes of the moral hazard effects generated by the introduction of Eurobonds in EU are likely larger than their respective counterparts in China.

Government Bailout Funds: Balancing Rules and Discretion

AbstractThis paper studies government bailout design in the face of economic failures by multiple firms, with ensuing threats to economic stability. Assuming that a commitment to a bailout magnitude is possible, yet cannot be made contingent on unforeseen circumstances, it is argued that the optimal policy consists of stipulating a bailout fund whose upper limit cannot be exceeded. Such an equilibrium policy provides a balance between flexibility to adjust to future circumstances and restraint of moral hazard incentive faced by the firms. An extension to the baseline model considers the case where corporate interests, divergent from those of the public, play a role, and the cap on bailout spending matters for the bargaining outcome between those interests.

Discussion Paper on Collaborative Business Models between Banks and FinTech for Green & Sustainable Growth

The discussion paper aims to solicit response from different stakeholders, including supervisory agencies, for understanding the risks and likely benefits of collaborative business models between banks and FinTech with an added emphasis on bringing coherence in multiple supervisory priorities like promoting FinTech,addressing climate-risks and sustainable development (SDGs).Though business models for collaboration vary in different jurisdictions, few important examples can be taken to identify common elements that can be replicated in other jurisdictions. The risks inherent in such business models especially in the context of immaturity of such business models, incompatible governance framework, moral-hazard and opaque incentive structures, among others, need to be carefully weighed in terms of benefits relating to market efficiency through better product design and wider distribution. Further questions for discussion are presented in the Annex.

Liquidity from Two Lending Facilities

During financial crises, the lender of last resort (LOLR) uses lending facilities to inject critical funding into the banking sector. The facilities need to be designed in such a way that banks are not reluctant to seek assistance due to stigma and that banks with liquidity concerns are attracted rather than those prone to risk-taking and moral hazard incentives. We use an unexpected disclosure that introduced stigma at one of two similar LOLRs during the Great Depression to evaluate whether banks used LOLR assistance to improve their liquidity needs using a novel trivariate model with recursive endogeneity. We find evidence that banks that approached the facility with stigma were less liquid and reduced their position of safe assets in comparison with banks that approached the facility with no stigma. Thus, stigma forced the pool of LOLR borrowers to separate into different groups of banks that ex-post revealed their liquidity preferences. This finding sheds light on why and when banks approach their LOLR.

Ordeals, inequalities, moral hazard and non-monetary incentives in health care

AbstractThis essay begins by summarizing the reasons why unregulated health-care markets are inefficient. The inefficiencies stem from the asymmetries of information among providers, patients and payers, which give rise to moral hazard and adverse selection. Attempts to ameliorate these inefficiencies by means of risk-adjusted insurance and monetary incentives such as co-pays and deductibles lessen the inefficiencies at the cost of increasing inequalities. Another possibility is to rely on non-monetary incentives, including ordeals. While not a magic bullet, these are feasible methods for addressing the inadequacies of market provision of health care, such as moral hazard.

How Important Is Moral Hazard For Distressed Banks?

The moral hazard incentives of the bank safety net predict that distressed banks take on more risk and higher leverage. Since many factors reduce these incentives, including charter value, regulation, and managerial incentives, the net economic effect of these incentives is an empirical question. We provide evidence on this question using two distinct periods that include financial crises and are subject to different regulatory regimes (1985–1994, 2005–2014). We find that distressed banks reduce their leverage and decrease observable measures of riskiness, which is inconsistent with the view that, on average, moral hazard incentives dominate distressed bank leverage and risk-taking policies.

Are the Largest Banking Organizations Operationally More Risky?

This study demonstrates that, among large U.S. bank holding companies (BHCs), the largest ones are exposed to more operational risk. Specifically, they have higher operational losses per dollar of total assets, a result largely driven by the BHCs' failure to meet professional obligations to clients and/or faulty product design. Operational risk at the largest U.S. institutions is also found to: (i) be particularly persistent, (ii) have a counter-cyclical component (higher losses occur during economic downturns), and (iii) materialize through more frequent tail-risk events. We illustrate two plausible channels of BHC size that contribute to operational risk -- institutional complexity and moral hazard incentives arising from "too-big-to-fail." Our findings have important implications for large banking organization performance, risk, and supervision.

The (un)intended effects of government bailouts: The impact of TARP on the interbank market and bank risk-taking

We analyze how the inflow of TARP funds in the wake of the 2007/2008 financial crisis impacted banks’ interbank market activity. We show that TARP banks’ interbank market activity was impacted in a statistically and economically significant way. Their interbank lending via federal funds sold increased by 77 percent relative to the mean of the control group of non-TARP banks. We further show that among the TARP banks, the most affected ones also increased credit risk taking, while at the same time not increasing profitability. These findings suggest a new, heretofore not investigated channel through which TARP may have increased banks’ moral hazard incentives.

Issuing Asset-Backed Money with Transparency: Monopoly versus Competition

I study the efficiency of issuing asset-backed money by comparing a competitive setting with a monopoly. In the model a money supplier can issue money by holding commodity such as gold, but they can also fake the quality of commodity at a proportional cost. There arises a haircut in the value of money transactions, when the moral hazard incentive becomes severe. Under perfect competition the decentralized issuers would provide money until the rates of return in money and gold are equal in equilibrium. This competitive equilibrium can be sub-optimal, because the individual issuers do not internalize the aggregate supply effect of issuing money on the prices and the haircut in general equilibrium. When the cost of faking assets is sufficiently small, the monopoly equilibrium is more efficient than the competitive equilibrium. Despite an inefficiency associated with the monopoly rent, the monopoly issuer can adjust the supply of money by considering the effects on the prices to reduce its own moral hazard incentive to raise the pledgeability of money and maximize the profit. Imposing a pigouvian tax and/or an entry cost can improve welfare of the competitive equilibrium by raising the transparency on the issuer’s moral hazard.

Additionality from Payments for Environmental Services with Technology Diffusion

Because payments for environmental services (PES) often subsidize practices that offer latent private benefits, there are concerns that PES programs may provide little additional environmental benefits. Previous literature has framed the problem of non‐additionality as an adverse selection problem. We develop a model where moral hazard can also arise because some agents delay adoption due to the incentive of potentially receiving a payment in the future. Moral hazard arises when agents have expectations of potential future subsidies, the technology naturally diffuses without a policy, and a subsidy is only available if the agent has not previously adopted the technology. We develop a conceptual model to illustrate the moral hazard incentive and conduct numerical simulations to understand the impact of policy parameters on aggregate outcomes. Numerical simulations illustrate that moral hazard creates a non‐monotonic relationship between policy parameters—such as the subsidy and budget levels—and the net change in adoption induced by the program because some agents delay adoption. We also find that the cost‐effectiveness of the policy is smaller when the policy is introduced during periods of rapid technology adoption.

Credit default swap and two-sided moral hazard

We consider the moral hazard incentives of the CDS (Credit Default Swap) buyer and seller simultaneously and show that the CDS trading raises both the seller and buyer’s moral hazard incentive compared with the situation without the CDS trading. Moreover, we demonstrate that the effects of strengthening the capital requirement with CDS are distinct from the circumstance without the CDS trading, which should be taken into account in the capital regulation.

Deposit insurance schemes and bank stability in Europe: how much does design matter?

ABSTRACTUsing a detailed set of deposit insurance schemes (DIS) features for 27 EU countries, we assess the impact of national deposit insurance features on bank stability and investigate the existence of non-linearities in the relationship between coverage and bank stability both in crisis and normal times. Our results suggest that more protective DIS do not necessarily lead to greater bank risk. However, during the crisis some features that generate moral hazard incentives can decrease bank stability. We find an inverse U-shaped relation with bank stability decreasing at high levels of coverage during the crisis period. However, our evidence also suggests that the introduction of temporary measures like blanket guarantees are crucial to avoid panic among depositors and restore stability. Finally, our results seem to imply that the stabilizing effect of deposit insurance can be different along the economic cycle, so regulators should consider that to be able to achieve an optimal DIS that minimizes moral hazard incentives a ‘dynamic’ approach may be necessary.

Evaluating Changes to Prevented Planting Provision on Moral Hazard

AbstractPrevented planting provision in crop insurance protects producers from failure to plant attributable to natural causes. We determined the impact of this provision at various crop insurance coverage levels on prevented planting claims and ex post moral hazard. The moral hazard incentive in the prevented planting provision is stronger for corn than soybeans. Reducing the prevented planting coverage factor for corn could likely reduce moral hazard, but the degree of the reduction will likely depend on the revenue protection coverage level. Conversely, we found moral hazard is unlikely to occur for soybean production regardless of the revenue protection coverage level.

The (Un)Desired Effects of Government Bailouts: The Impact of TARP on the Interbank Market and Bank Risk-Taking

We analyze how the inflow of TARP funds in the wake of the 2007/2008 financial crisis impacted banks’ interbank market activity. We show that TARP banks’ interbank market activity was impacted in a statistically and economically significant way. Their interbank lending via federal funds sold increased by 77 percent relative to the mean of the control group of non-TARP banks. We further show that among the TARP banks, the most affected ones also increased credit risk taking, while at the same time not increasing profitability. These findings suggest a new, heretofore not investigated channel through which TARP may have increased banks’ moral hazard incentives.

E-Money: Legal Restrictions Theory and Monetary Policy

This paper studies the efficiency of electronic money system by focusing on the decentralized setting of issuance. In the model competitive money issuers can create small denominated money (or e-money) backed by large denominated government bonds. Under the decentralized environment the issuers can also produce counterfeit collateral at a proportional cost. This moral hazard incentive requires the more government bonds for the issuers to provide the same amount of money. In general equilibrium the individual money issuers do not internalize the aggregate effect of money supply. Thus the equilibrium allocation is constrained inefficient with the moral hazard incentives. We suggest a pigouvian tax on money supply to correct the externality in aggregate money supply.