Safe Banking to Avoid Moral Hazard
Publisher: Journal of Risk Management in Financial Institutions
Published: April 2008
Place of publication: UK
Description: This paper argues that the moral hazard risk faced by a banking or non-banking firm can be dissipated due to arbitrage trading in a market economy.   This implies an optimal policy for (a) discontinuation of government insurance or regulation or intervention of banks and (b) promotion of market-based safe banks which invest only in government securities and universal banks that invest in all assets.  Safe banks can serve the panic-prone depositors and thus minimize the systemic risk faced by an economy due to banking panics and runs.  The risk premium on assets of a levered firm can be shown to be negatively related to asset volatility.  The minimum threshold asset-to-debt ratio below which a firm goes bankrupt is an increasing function of the asset risk premium.
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