Not so with private debtors. In remarks made by Gary Stern, President
of the Federal Reserve Bank of Minneapolis, to the 35th Annual
Conference on Bank Structure and Competition, on May 1999, he said:
"I propose combining market signals of risk with the best aspects of
current regulation to help mitigate the moral hazard problem that is
most acute with our largest banks ... The actual regulatory and legal
changes introduced over the period-although positive steps-are
inadequate to address the safety net's perversion of the risk/return
trade-off."
This observation is truer now than ever. Mass-consolidation in the
banking sector, mergers with non-banking financial intermediaries (such
as insurance companies), and the introduction of credit derivatives and
other financial innovations - make the issue of moral hazard all the
more pressing.
Consider deposit insurance, provided by virtually every government in
the world. It allows the banks to pay to depositors interest rates
which do not reflect the banks' inherent riskiness. As the costs of
their liabilities decline to unrealistic levels -banks misprice their
assets as well. They end up charging borrowers the wrong interest rates
or, more common, financing risky projects.
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