Bank moral hazard in the U.S. and the EU

Risk transfer in the banking industry is closely linked to moral hazard. In this sense, leaving the lender-borrower relationship aside, a standard moral hazard problem is that where shifting risk to third parties may create incentives for risky banks to take more risk and keep operating at the expense of others. This moral hazard problem has been deeply analyzed in relation to banking policies and regulation; specifically, in relation to flat-rate deposit insurance and the role of central banks as lender of last resort. In both cases, moral hazard problems could arise because managers, investors or depositors undervalue the risks (and overvalue the potential benefits) of risky investments, since they expect the safety net to protect them in case of trouble.

              Nevertheless, moral hazard does not just arise when risk might be transferred to the safety net. Potentially, moral hazard is present whenever risky asset growth is not funded with equity; and the riskier asset growth is and the less it is funded with equity, the more severe is the moral hazard problem. As King et al. (2006) put it, banks with relatively high capital ratios have incentives to manage their banks prudently, because the owners of the bank have their own funds at stake. By contrast, in accordance with the interpretation of equity as a call option, when equity is a relatively small fraction of a bank's liabilities, management might prefer to book high-risk assets.

              The aim of this paper is to analyze this type of potential moral hazard problem. In particular, we study whether there is any relation between changes in bank risk and how banks fund their asset growth. The standard way in which the literature has analyzed this question has been to relate changes in risk to changes in equity. However, we do not follow this methodology. We depart from it in two  relevant ways. First, besides equity, we consider other components of the liability side of the balance sheet. Second, rather than considering changes in the liability components themselves, we consider changes of these components in relation to changes in assets. This marginal view makes it possible to relate asset growth, funding sources and risk, and hence, provides an answer to the key question of moral hazard: How do banks that become riskier fund their asset growth?

              To test these hypotheses concerning moral hazard behavior, we use a sample formed by commercial banks, saving banks and cooperative banks in the USA and the European Union (EU). Alhtough we also study the period 2007-09, our analysis focuses on the period 1996-2006. Thus, we can study the moral hazard problem in the context of rapid asset growth that preceded the financial crisis. As regards this period, our main findings can be summarized as follows. For the USA and UE12, empirical estimations support the hypothesis that banks engaged in moral hazard behavior during the sample period. By contrast, our analytical framework does not allow us to conclude whether banks exhibited or not this behavior.