Liquidity Preference in Maturity Transformation: The Federal Reserve as Lender of Last Resort, Moral Hazard, and the Theory of Unlimited Protection

Abstract

This thesis explores the doctrine of Unlimited Protection, the expansion of the Federal Reserve’s role as Lender of Last Resort, and the resulting effects on contemporary banking structures and conditions for moral hazard. I hypothesize that over the past fifty years, the doctrine of Unlimited Protection (in which the Federal Reserve mitigates bank failure at all costs) has incentivized banks to engage in greater risk-taking, knowing that during times of banking stress, the Federal Reserve will intervene to support insolvent banks. I hypothesize that this has set up a condition of support for moral hazard, encouraging banks to engage in riskier operational strategies. In this study, I conducted a series of regression analyses on data from the ten-year period leading up to the 2008 financial crisis to test the correlations between bank failure, leveraged bank securities trading, and CEO net stock sales, where CEO net stock sales represent conditions of moral hazard. I found that banks which: (i) focused on bank securities trading; and (ii) used highly leveraged trading structures, were also (a) more likely to have CEOs who sold more of their firm’s shares (relative to their peers); and (b) more likely to fail. Firms that engaged in more bank trading (relative to their peers) were highly correlated with firms whose CEOs engaged in greater levels of net stock sales. Indeed, both net stock sales and bank securities trading were also highly correlated with firm failure. Thus, this thesis finds that operational risk-taking resulted in many firms failing, and that such failure was associated with personal financial enrichment for CEOs who sold their firm’s shares. The results of my regression analyses support the hypothesis that the Federal Reserve’s contemporary role as Lender of Last Resort fostered conditions for increased moral hazard and bank failure.