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.
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Author's Biography
Sankarshan Acharya is Associate Professor of Finance at the University of Illinois at Chicago. Sankarshan holds doctorate and masters degrees, respectively, from Northwestern University and the Indian Institute of Technology. His research includes valuation of latent assets, optimal bank regulation, CEO compensation, and arbitrage pricing of derivatives, published in leading journals like the Journal of Finance and International Economic Review. His policy research has been used in the Federal Deposit Insurance Corporation Improvement Act and Basel Accords of the Bank of International Settlements. He has counselled the governments of the USA, India and China.
Citation
Acharya, Sankarshan (2008, June 1). Safe banking to avoid moral hazard. In the Journal of Risk Management in Financial Institutions, Volume 1, Issue 3. https://doi.org/10.69554/MILD9036.
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