Subordinated Debt: Tough Love for Banks?

Good parents understand the perils of overprotection. They know that letting their children grow up often means letting them take their lumps. The past two decades have reinforced a similar principle with respect to the safety and soundness of banks. Government protection sometimes does as much to create the problem as to solve it. Here is the economics of moral hazard: Banks, secure in the safety net offered by the government, feel free to take increasingly risky positions. Depositors, knowing their deposits are safe, don’t care and will neither withdraw their funds nor demand a higher interest rate. The deposit insurance system then effectively insulates the bank from market discipline.