Moral Hazard and Bank Bailouts

My mind goes back to 2008. I was recently tempted to ask why bad loans by banks are a public problem. I was tempted to say that the bank made the loan, so it is their problem. If enough debtors default that the bank fails, so what? Then I remember the very appealing logic of the argument that, while other banks are free to save Lehman if they choose, no public money should be involved. That didn’t work out very well. The tempting pure market let banks sink or swim doctrine is, in fact, stupid. If they sink, they bring a lot of ordinary people down with them. A convincing promise to not bail out banks reduces moral hazard problems. It would be good, so long as it were a successful bluff. But actually, letting lots of large banks fail is not good policy.

However, the fact that from time to time we have to bail out big banks does not at all imply that we have to bail out top bankers. I am sure that they are sincerely convinced that they are geniuses, and I am also sure they are wrong. I think the threat should be that the bank won’t be allowed to go bankrupt but, if it has to be bailed out, its top officers certainly will.

This is not possible with current law (and may not be possible in the USA with the current Supreme Court) but it is, in theory possible. A banking act which says that the top officers of the bank must pledge all of their wealth permanently can be written. It will not be impossible to fill the jobs with such a law. The top officers can be defined in terms of total compensation (as in they are paid only in cash with no other benefits especially including options but also including anything which might be construed as a fingebenefit (by a jury of banker hating citizens)). Also, if this compensation is over $1,000,000 per year (to be indexed to the CPI) then the employee is a top officer and all possessions may be seized if the bank is bailed out (and no gifts except to 401 (c) 3’s allowed).

Now it is certainly true that most financiers will refuse to work for banks and set up hedge funds and such. Also so what ? I don’t think one has to be very smart to operate a sound bank.

Now a problem is that there are firms which are, in effect, banks, but which don’t take deposits (eg Lehman Brothers). They can be targetted (they were by Dodd-Frank).

What’s the problem ? I mean such a law will certainly not pass Congress as they are bought by bankers, but what is the problem with the policy as policy ?