Safe banking to avoid moral hazard

Abstract

This paper argues that the moral hazard risk faced by a banking or non-banking firm can be dissipated by arbitrage trading in a market economy. This implies an optimal policy for (a) discontinuation of government insurance, regulation or bank intervention and (b) promotion of market-based safe banks that only invest in government securities and universal banks that invest in all assets. Safe banks can serve panic-prone depositors and thus minimise the systemic risk faced by an economy due to banking panics and runs. The risk premium on assets of a leveraged firm can be shown to be negatively related to asset volatility. The minimum asset-to-debt ratio threshold below which a firm goes bankrupt is an increasing function of the asset risk premium.