Safe banking to avoid moral hazard

Sankarshan Acharya

Journal of Risk Management in Financial Institutions, 2008, vol. 1, issue 3, 297-310

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.

Keywords: efficient resolution of moral hazard; arbitrage pricing; hedging; safe banking policy (search for similar items in EconPapers)
JEL-codes: E5 G2 (search for similar items in EconPapers)
Date: 2008
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Persistent link: https://EconPapers.repec.org/RePEc:aza:rmfi00:y:2008:v:1:i:3:p:297-310

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