Moral Hazard in Banking

Dear Colleagues,

The recent global financial crisis has reignited interest in the topic of moral hazard in banking. Theoretically, safety nets should prevent bank runs (Diamond and Dybvig, 1983) and therefore preserve financial stability. However, deposit insurance and other types of government guarantees (both implicit and explicit) may increase bank risk-taking because of the isomorphic relation between insurance and a put option (Ronn and Verma, 1986). Recent contributions have provided evidence of moral hazard in banking deriving from bailouts expectations (Dam and Koetter, 2012), as well as risk-shifting in the form of dividend payments (Acharya et al., 2011; Onali, 2012).

Capital adequacy regulation is supposed to reduce the perverse incentives generated by government guarantees by forcing bank owners to have some ‘skin in the game’. However, capital requirements in a liberalized banking system may result in lower franchise values, and the overall impact of capital requirements on bank risk-taking is hard to assess a priori (Hellmann, Murdock, and Stiglitz, 2000).

The new Basel III framework aims at reducing moral hazard. To achieve this objective, the Basel Committee on Banking Supervision has proposed a number of amendments to the current regulation encompassing all three pillars of the framework (minimum capital requirements based on risk-weighted assets, supervisory review process, and market discipline). However, further theoretical and empirical research is warranted to assess the effectiveness of different types of banking regulation in reducing moral hazard and to understand the extent to which the Basel III framework addresses the pitfalls of the current rules.

Dr. Enrico Onali
Guest Editor

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• moral hazard
• bank risk-taking
• risk-shifting
• prudential regulation
• deposit insurance
• bank bailouts
• systemically important financial institutions
• Basel III
• managerial incentives
• market discipline