Tunneling Money through Related-Party Lending

Abstract

Every bank has a certain level of moral hazard. When banks take on big risks, shareholders and employees, who are incentivized through cash bonuses, benefit from the if the results are positive. If market circumstances are unfavorable—even if fraudulent behavior has been practiced within the bank—the shareholder only bears part of the loss. The rest of the loss from the risk taking is borne by creditors, bondholders, uninsured deposit holders. In the case of systemically important institutions it is the public that picks up the tab. This is commonly referred to as privatization of gains and socialization of losses.¹