Global Bank Regulation

Chapter 4

The Financial Safety Net and Moral Hazard

In the preceding two chapters we observed that banks are vulnerable to a sudden and unexpected loss of funding (the classic run on the bank) and that the highly interconnected financial system may cause domino-like collapses of banks or, in more recent years, asset price spirals that ultimately undermine banks’ solvency. Once the contagion spreads to otherwise healthy banks, the economy and society can suffer serious damage.

Banking crises are extremely costly in economic terms. In particular, growth and output opportunities are foregone, as is illustrated by the decade of stagnation that followed Japan’s banking crisis in the early 1990s. Estimating just how much output has been lost is extremely ...