By Dr. Jeffrey Herbener

Moral hazard occurs when an agreement people make to act in concert for their mutual benefit results in an incentive for one of them to act immorally. The classic case is insurance. When an insurance company contracts with a homeowner to provide fire insurance, the homeowner now has incentive to pay a few premiums and then burn his house down and collect a full insurance payout. In committing arson, not only does the homeowner harm the material well-being of the owners of the insurance company and the innocent homeowners who are abiding by their promises, he injures his own spiritual well-being. He has defrauded those who trusted him to keep his word. In response to the possibility of arson, the insurance company assembles an arson investigation team to detect such immoral behavior. Mitigating moral hazard is a wise course of action because it limits the harm to all involved. It would be foolish for the insurance company to overlook the harm of moral hazard or, even worse, to arrange its affairs in a way that augmented moral hazard.

The potential for moral hazard permeates human relationships. Wisdom councils us to look for ways to mitigate the damage of moral hazard and avoid acting in ways that create moral hazard. In one area, regrettably, moral hazard has become a way of life.

Moral hazard is endemic to a banking system regulated by a central bank. Consider the current banking crisis. As reported by Dr. Peter St. Onge on March 19, total unrealized losses in the banking system are between $1.7 trillion and $2 trillion. The capital buffer for the entire system is $2.2 trillion. The banking system, therefore, is on the verge of insolvency. Furthermore, there are 186 banks in distress and hundreds with losses bigger and capital buffers smaller than Silicon Valley Bank.

The main culprit in these losses is the Federal Reserve’s more than decade-long policy of suppressing interest rates. Cheap credit has given an incentive to investors and entrepreneurs to pour funding into all kinds of projects and practices that will prove to be financially unviable. Monetary inflation is the fuel needed to increase the supply of credit and keep interest rates suppressed. The unwinding of the quantitative-easing policies of the Fed after 2014 was quickly abandoned in the repo crisis of 2019. But it was the monetary inflation of the Fed to fund the fiscal explosion of the federal government during the Covid lockdown that has resulted in the current return of significant price inflation. In turn, higher price inflation rates are now causing interest rates to rise. Rising interest rates on newly issued Treasuries have collapsed the market prices of the low-interest-rate Treasuries that banks acquired in the past and are holding now because regulatory bodies consider them safe. Of the nearly $17.5 trillion in bank credit in the banking system, roughly $4.4 trillion is Treasury and Agency securities and another significant but unknown portion of bank credit is now unprofitable loans undertaken during the period of cheap credit. Clearly, the Fed’s policy actions have led to the current crisis.

In turn, the Fed’s policy of suppressing interest rates was the result of the quantitative easing begun under Ben Bernanke because of his belief that without an unprecedented monetary inflation in the wake of the financial crises of 2007, the banking system would collapse and usher in another Great Depression. Although we can’t test Bernanke’s prediction to see what would have happened in the absence of his monetary inflation experiments, we are living through its consequences. As the banking system lurches from one crisis to the next, perhaps the time is fast approaching where fundamental reform may get a fair hearing.

In the meantime, the ground for the next banking crisis is being laid by the policy solution to the current crisis. The Treasury, the Fed, and the FDIC have pledged to make depositors whole. Doing so perpetuates the incentive to which the large depositors succumbed in holding account balances far in excess of the FDIC-insured maximum of $250,000. As reported by Doug French, $151.6 billion or 86% of the total deposits of $175.4 billion at SVB were uninsured. By making depositors whole, their reckless behavior will be perpetuated and the problem government officials are trying to solve will emerge in a more virulent form in the future. Backstopping depositors this time is just the latest extension of a tradition of treating certain institutions as “too big to fail.”

It’s disingenuous for government officials to claim that taxpayers will not be on the hook for making depositors whole. Someone will suffer for the immoral behavior of depositors and bank officials. If the FDIC obtains the funding by raising fees on other banks and their depositors, the innocent suffer for the guilty just like the homeowners who pay their premiums while arsonists collect insurance company payouts. Fed monetary inflation is the other alternative to raising taxes to fund the payouts to depositors.

As with taxation, monetary inflation redistributes income. The first receivers, in this case SVB’s depositors, get the new money first and spend it to obtain goods and services they want to buy. Without Fed monetary inflation, however, these goods and services would have gone to others. And if SVB depositors’ command over goods and services is maintained because of monetary inflation, it comes at the expense of those who receive the new money later in the process of spending and receiving the new money across a wider circle of people. The late receivers will have to pay higher prices brought about by the spending and receiving process. Although the depositors are richer than they would have been without the Fed’s monetary inflation, the late receivers of the new money and those who do not receive the new money at all are poorer. Why would anyone support a government policy that restores the wealth of richer persons who have acted imprudently at the expense of poorer persons who are innocent?

Clearly, the Fed will be called upon to use monetary inflation to pay the depositors. The FDIC Deposit Insurance Fund stood at $128 billion on December 31, 2022. At that time the DIF constituted 1.3% of the account balances it insured. In addition to those of SVB, the uninsured deposits of Signature Bank are around $79 billion, bringing the total commitment to cover uninsured depositors in the two failed banks to around $230 billion, which dwarfs the FDIC’s DIF by $100 billion. Since the Treasury is swimming in debt, it’s unlikely that taxes will be raised to pay depositors. If fact, the Fed has already answered the call to inflate the money supply to fund payments to depositors. From the week ended on March 15, Reserve Bank Credit increased $211 billion. It now stands at $8.657 trillion, which is $353 billion greater than its Quantitative Tightening low point on March 9 and only $262 billion short of its peak of $8.919 trillion reached on May 18, 2022.

As a modest proposal to help prevent a repeat of this particular episode of moral hazard, states and national charters for banks could be given to strictly deposit banks, i.e., to money warehouses, that merely safekeep depositors’ money which remains fully available to them to spend. Of course, such banks would charge fees for being money custodians. But their existence would eliminate the moral hazard of backstopping large, uninsured depositors in fractional-reserve banks. Workers and suppliers would have incentive to deal with companies that kept their demand deposits at warehouse banks and not bear the uncertainty of dealing with a customer of another SVB who can’t make payroll or pay for supplies during a bank panic. Competition would exert pressure on other companies to follow suit. In fact, warehouse banks might be popular with households, too. Thereby reducing, and perhaps eliminating, the need for FDIC protection and the destructive incentives it creates for depositors.

Backstopping depositors is, regrettably, only the proverbial tip of the iceberg of moral hazard in our money and banking system. Should we expect bank regulators to act diligently and with acumen when they face no consequences or even have their power and budgets expanded after they fail to even notice, let alone forestall, an impending crisis? And should we expect politicians to act soberly and prudently in considering policy for the common good when they have access to the Fed’s printing press?

At least one former Federal-Reserve insider recognizes that our central banking system has made moral hazard a way of life. What’s needed is fundamental reform. When will we abandon the foolish path of enacting policies that extend the scope of moral hazard? If we refuse to abandon the foolish path, we risk burning our house to the ground.

Dr. Jeffrey Herbener is chair of the department of economics at Grove City College and fellow for economic theory & policy with the Institute for Faith and Freedom.