Friday, September 2, 2011

Liquidity support leads to excessive risk-taking (amv)

Incentive systems play a pivotal role in economics (as I argue here). As already emphasized by Adam Smith, the extent to which markets translate 'individual rationality' into 'collective rationality' (i.e., the extent to which markets are 'efficient') depends on institutional configurations or, more precisely, on the proximity of actual institutions to the 'system of natural liberty'.  Mark Mink (© applies neat rational-choice reasoning to 'show' that an institutional setting characterized by central bank liquidity support is likely to cause excessive risk-taking and, thus, is likely to cause (future) instability:
"Since the outbreak of the global financial crisis in 2007, and particularly since the bankruptcy of Lehman brothers in September 2008, central banks in their roles as lenders of last resort have provided large-scale liquidity support not only to individual banks, but also to the banking sector as a whole. [...] While these extraordinary measures were deemed inevitable in stabilising the banking sector, in Mink (2011) I show that the prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner."
In other words: there ain't no such thing as a free lunch!