# Is choosing an investment by a bank only due to its regulatory capital charge a form of moral hazard?

The main shortcoming of the first Basel Accord (Basel I) was that its capital requirements did not reflect the actual risk of the bank assets.

One way this nonsense influenced the asset choice of banks was: risk being equal, they chose to reduce the availability of credit to some categories of borrowers shifting towards other categories with lower capital charge, at the expense of more socially preferable investments.

Now, suppose a bank has to choose between granting a loan to Company A and another investment, B, both equally risky.

Suppose that, due to the regulation rules, the bank has to put aside 150\$of capital if it grants the loan to A or 100\$ if it invests in B. Hence, it will invest in B.

The same reasoning is valid for all the A-like companies and B-like investments, therefore it creates a credit crunch towards the former.

According to https://dictionary.cambridge.org/dictionary/english/credit-crunch, credit crunch is defined as:

economic conditions that make financial organizations less willing to lend money, often causing serious economic problems

and this is bad for the regulator (which is the Central Bank or a similar State Agency).

Is this behavior by the bank (the agent) with respect to the regulator (the principal) a sort of moral hazard, taking into account that the actual riskiness of the companies is known by the bank but not by the regulator?

• In what way does B not getting a loan incur costs for the regulator? – 410 gone Jun 20 '18 at 4:51
• @EnergyNumbers The credit crunch is the cost, broadly. The regulator is the central bank and it should promote a correct credit allocation. – CarLaTeX Jun 20 '18 at 4:55
• A credit crunch is when lots of credit is withdrawn. You seem to be talking about something different: an absence of credit being granted, and I don't see how that creates a cost to the regulator. By the way, the regulator is not necessarily the Central Bank. Perhaps you mean the state is the principal? And it's unclear in your question as to the measure by which "both companies are equally risky" yet one merits higher capital requirements than the other. – 410 gone Jun 20 '18 at 5:45
• Wheres the cherry-picking? – Mozibur Ullah Jun 20 '18 at 5:51
• @EnergyNumbers Your comments seem to thoroughly answer this question. Combine and post them as an answer? – Giskard Jun 20 '18 at 7:01

In economics, moral hazard occurs when someone increases their exposure to risk when insured.

Moral hazard is idea that a party protected in some way from risk will act differently than if they didn't have that protection. We encounter moral hazard every day—tenured professors becoming indifferent lecturers, people with theft insurance being less vigilant about where they park, salaried salespeople taking long breaks, and so on.

Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.

A moral hazard occurs when acting causes the behavior against which you are acting to increase.

For example, bailing out a bank due to risky loans that the bank took encourages future banks to make riskier loans. If the loans pan out, they make a lot of money. If the loans fail, they get a bailout. A bailout is less harmful than a bankruptcy, so they view it as less of a risk. The bailout avoids a bankruptcy today, but it puts more companies at risk of bankruptcy tomorrow.

In your example, you have two equally risky companies (or types of companies). But the regulations regard one as riskier than the other. So they encourage investment in one investment over the other. That's the intended goal of the policy. It's not a moral hazard if it is encouraging the intended behavior.

Now, it may be that the policy is misguided and distorts the market in ways that are not intended. But that is not a moral hazard. It would only be a moral hazard if the rule were intended to encourage increased investment in A but due to the way it changed the incentives, it actually increased investment in B.

• I don't think this is the definition of moral hazard at all. Could you please back it up with a source? – Giskard Jun 23 '18 at 7:37
• This is still misleading: "moral hazard occurs when acting causes the behavior against which you are acting to increase.", and is not consistent with the referenced sources – 410 gone Jun 24 '18 at 6:44

"moral hazard" is probably not a good word to describe this, although it clearly can be related.

"moral hazard" (in this context) is when the bank makes riskier-than-optimal loans under the assumption that someone else will pick up the tab if a black swan event occurs. Or, more generally, something which systematically reinforces incentives to place costs (or risk) on a third party, while enabling the investor(s) to retain the full benefit with inadequate or no insurance. The result is then a "too-risky" loan portfolio relative to the optimum.

While the bank may indeed make calculated decisions in this context to make loans on the basis of some financial instrument or asset (e.g., loan) satisfying criteria to qualify as a specific form of capital when the underlying quality is in fact lower, that is not what would make it moral hazard.

What would make it moral hazard is if the bank were specifically calculating on the basis of known classification issues which would enable them to earn some flows of income which are 'too high' due to the ability to place cost or risk on the regulator or taxpayer. For example, without having to pay for insurance, or underpaying for insurance.

I.e., even if done in a manner 100% consistent with the letter of the regulations, it is not the fact of some classification issue which enables to classify some volume of in-fact-low(er)-quality loans as high(er) quality loans to satisfy some regulatory requirement that makes it "moral hazard". But, rather, what makes it "moral hazard" is the incentive to place cost or risk on third parties who obtain 'insufficient' or no exposure to the upside.

Is this behavior by the bank (the agent) with respect to the regulator (the principal) a sort of moral hazard, taking into account that the actual riskiness of the companies is known by the bank but not by the regulator?

No, it is not moral hazard. And I would add that it is not morally/economically wrong either.

The bank's decision to lend money to option B might be driven from B's expected return being higher than A's, which could be symptomatic of A's lack of competitiveness. The bank does not have a duty to insure or subsidize A.

Nor is the bank's duty to accommodate the regulator's inaccurate assessment of risks. In fact, if for whatever reason the bank accommodated the regulator's misconception despite [bank's] knowledge that risk(A) = risk(B) and expected_return(A) <= expected_return(B), funding A could contribute to creating a credit crunch in the sense that those resources could have been lent to other options that are more deserving (be it in terms of lower risk or of higher return at the same risk) of that loan.