Wednesday, October 22, 2008

Punishing the Prudent

One of the many problems with the current government response to the recent financial events is that of “moral hazard." Signals are sent that if you take risks and loose, you won't have to suffer full consequences. By blunting the negative effects of excess risk or erroneous investment, those activities are not adequately discouraged. Every level of risk becomes "safer" because of the safety net being provided by the government, which really means the taxpaying citizens.

Rescuing failing, or even struggling, institutions, undermines market discipline. The beauty of market discipline is that it rewards correct decisions and punishes wrong decisions, thus shifting resources to those who will invest them more wisely. Bailouts reverse the normal incentives. The failures are rewarded and the prudent are punished.

From the Washington Post:

Peter Fitzgerald, chairman of Chain Bridge Bank in McLean, said he was "much chagrined that we will be punished for behaving prudently by now having to face reckless competitors who all of a sudden are subsidized by the federal government."

At Evergreen Federal Bank in Grants Pass, Ore., chief executive Brady Adams said he has more than 2,000 loans outstanding and only three borrowers behind on payments. "We don't need a bailout, and if other banks had run their banks like we ran our bank, they wouldn't have needed a bailout, either," Adams said.

And from John Allison, President and CEO of BB&T in an open letter to members of Congress:

While all financial intermediaries are being impacted by liquidity issues, this is primarily a bailout of poorly run financial institutions. It is extremely important that the bailout not damage well run companies.
Corrections are not all bad. The market correction process eliminates irrational competitors. There were a number of poorly managed institutions and poorly made financial decisions during the real estate boom. It is important that any rules post “rescue” punish the poorly run institutions and not punish the well run companies.

If prudence and success are punished and imprudence and failure are rewarded, just how long can we maintain prosperity?

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