We all know you can’t insure a car for more than it’s worth. This is because insurance companies understand something called moral hazard. Moral hazard is a concept saying that people will take risks if they have an incentive to do so. Ergo, if my car is only worth $10,000 but it’s insured for $20,000, then I might be tempted to torch it.
Moral hazard can entice individuals insulated from risk to behave differently than they would if fully exposed to the risk. Examples include tenured professors becoming indifferent lecturers, insured drivers being less vigilant about car theft, protected managers making poor decisions and unemployed workers being less inclined to look for a job while on government benefits.
The subprime crisis is another example of moral hazard. Many US financial institutions recklessly lent money to people with poor credit histories to buy overpriced houses. They deliberately lowered their credit assessment standards knowing they could package dodgy loans into mortgaged backed securities and pass off the risk of default to unsuspecting investors.
Moral hazard is commonly associated with any type of safety net including deposit insurance. At the height of the GFC, governments around the world guaranteed the deposits of citizens in banks and other financial institutions. Most commentators believe this unprecedented intervention was necessary to protect the global financial system from meltdown (see earlier blog).
As the crisis passes, the OECD is urging Australia to fulfil its promise to remove its deposit guarantee which, it argues, is a moral hazard. Notwithstanding this, the OECD acknowledges that both depositors and banks now believe the Federal Government will always come to their rescue in times of trouble.
The belief that a bank is too big to fail represents a classic moral hazard. If the public and the management of a financial institution believe it will receive a financial bailout to keep it going, management - in theory - may take more risks in pursuit of profits. Yet, there’s no evidence that the deposit guarantee has actually encouraged Australia’s Approved Deposit-taking Institutions (ie, banks, building societies and credit unions) to behave recklessly.
We have a strong prudential regulatory system governing Approved Deposit-taking Institutions (ADIs) in Australia. While there’s no doubt that moral hazard in financial services is real, our robust regulation and good practices prove that this risk can be mitigated.
The GFC shows that governments will act to save banks which are too big to fail. This gives our Big Four banks an implicit guarantee and an unfair advantage over smaller credit unions. That’s why I believe the current retail deposit guarantee scheme (known as the Financial Claims Scheme) should be maintained after its proposed review date in October 2011.
As someone who is a staunch believer in free markets and survival of the fittest, I can fully understand why the RBA opposes the extension of the deposit guarantee. I too accept that governments should not be the first port of call in times of crisis. However, some form of depositor safety net for all ADIs is essential to provide a more level playing field for Australian credit unions and building societies.
The deposit guarantee scheme provides protection for ordinary depositors, fosters competition in banking and doesn’t cost the taxpayer a cent. In short, it’s a necessary evil if we are serious about the mutual sector being a viable alternative to the Big Four banks.
Regards
Paul J. Thomas
Podcast is available here 
Posted Monday, September 06, 2010 
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