macroresilience

resilience, not stability

Moral Hazard: A Wide Definition

with 19 comments

A common objection to the moral hazard explanation of the financial crisis runs as follows: No banker explicitly factored in the possibility of a bailout into his decision-making process.

The obvious answer to this objection is the one Andrew Haldane noted:

“There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks?

Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue. The time- consistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities.”

Bankers did not consciously take on more risk. They took on less protection against risk, particularly extreme event risk.

But this too is an unnecessarily limited definition of moral hazard. Moral hazard can persist without any explicit intention on the part of the agent to behave differently.

Spontaneous Order

It is not at all necessary that each economic agent is consciously aware of and is trying to maximise the value of the moral hazard subsidy. A system that exploits the subsidy efficiently can arise by each agent merely adapting to and reacting to the local incentives and information put in front of him. For example, the CEO is under pressure to improve return on equity and increases leverage at the firm level. Individual departments of the bank may be extended cheap internal funding and told to hit aggressive profitability targets without using capital. And so on and so forth. It is not at all necessary that each individual trader in the bank is aware of or working towards a common goal.

Nevertheless, the system adapts in a manner as if it was consciously directed towards the goal of maximising the subsidy. In other words, a Hayekian spontaneous order could achieve the same result as a constructed order.

Natural Selection

The system can also move towards a moral hazard outcome without even partial intent or adaptation by economic agents given a sufficiently diverse agent strategy pool, a stable environment and some selection mechanism. This argument is similar to Armen Alchian’s famous paper arguing for the natural selection of profit-maximising firms.

The obvious selection mechanism in banking is the principal-agent relationship at all levels i.e. shareholders can fire CEOs, CEOs can fire managers, managers can fire traders etc. If we start out with a diverse pool of economic agents pursuing different strategies, only one of which is a high-leverage,bet-the-house strategy, sooner or later this strategy will outcompete and dominate all other strategies (provided that the environment is stable).

In the context of Andrew Haldane’s comment on banks’ neglect of risk management, banks that would have invested in risk insurance would have systematically underperformed their peer group during the boom. Any CEO who would have elected to operate with low leverage would have been fired a long time before the crisis hit.

To summarise, moral hazard outcomes can and indeed did drive the financial crisis through a variety of channels: explicit agent intentionality, adaptation of agents to local incentives or merely market pressures weeding out those firms/agents that refuse to maximise the moral hazard free lunch.

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Written by Ashwin Parameswaran

January 1st, 2010 at 8:30 pm

19 Responses to 'Moral Hazard: A Wide Definition'

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  1. One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time. Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards. The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

    But, regulators are to a degree subject to politicians. Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well. Thus, regulations were neutered.

    After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay? There were some bankers that did so and got shown the door. There were other banks owned privately, were conservative, and missed the crisis. It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

    Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics. Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

    Someone has to care for the long run. Better it be free individuals rather than the government. But if free individuals will not do it, eventually the government will.

    David Merkel

    2 Jan 10 at 9:41 am

  2. Bill Martin, the Fed Chairman in the 50s and 60s once said, ” The function of the Federal Reserve is to take away the punch bowl just as the party is getting good.”

    Well, the present day Fed most certainly does not follow Bill Martin’s philosophy!

    admin

    2 Jan 10 at 6:32 pm

  3. great blog. I just read all of your posts.
    The system we have built will fail completely. The process has already started, but is being held up by a piece of string by the government.
    It isnt robust enough to survive.

    shrek

    3 Jan 10 at 12:48 pm

  4. I discovered your blog from a link on David Merkel’s Aleph Blog. I was thrilled to read your posts relating to complex systems etc. This is an area I’ve been delving into for 7-8 years and even launched my own mutual fund recently based largely on my application of basic concepts I’ve cobbled together from people such as Hayek, Mandlebrot and others. I look forward to your future posts – thanks for being generous in sharing.

    James Dailey

    3 Jan 10 at 9:15 pm

  5. […] Bankers were subject to moral hazard without considering the possibility of a bailout: they may not have even had any awareness of acting differently.Close […]

  6. Thank you James. There will certainly be a lot more on the topic of the economy as a complex system on this blog. The purpose of the blog is to shares some ideas I’ve developed over the last few years and any feedback would be most welcome.

    admin

    6 Jan 10 at 6:42 pm

  7. Shrek – Thanks, the central theme of this blog is the fragile nature of our economic system and how our current structures and policies are making it even less resilient.

    admin

    6 Jan 10 at 6:46 pm

  8. One of my defining moment memories was being told that I needed to “have more flexible ethics” when I refused to provide a favorable tax opinion on a “financial innovation”. My years in dealing with the financial industry definitely gave me the impression that so long as the boom exists, the “bet the farm” types will crowd out the conservative or moderate risk types.

    Bryan Emrys

    4 Feb 10 at 6:48 pm

  9. […] lunch available courtesy of the taxpayer. The essential idea which I outlined at the end of this post is as follows: The current regime of explicit and implicit bank creditor protection and regulatory […]

  10. Sounds like it all comes down to leverage. if the system has enough leverage that is a SUFFICIENT condition for moral hazard. Leverage can take the form of debt and options, which exist on more than one level in our economy – executive/money manager incentives and financing.

    In fact our political process has some elements of this where politicians can through out random economically neutral initiatives to see if they generate public support, while at the same time rewriting laws to benefit special interests who sponsor both sides (illusion of choice).

    all in all, we pretty much have to start over, which is not feasible. However i’m optimistic that technological progress isn’t subject to the evils of this society, so the most important thing we can do is make sure that the internet remains free, particularly if it means greater transparency. Privacy is something we have to give up to fix information asymmetry.

    what do you think?

    Alex Golubev

    18 Feb 10 at 6:11 pm

  11. Alex – the key assertion I am making is that the increased leverage is a product of the moral hazard problem. Increased leverage increased the moral hazard subsidy that a bank can extract from the taxpayer.

    admin

    19 Feb 10 at 2:14 am

  12. but it’s not just the taxpayer. there are generations of less-levered failed banking business models which allocated resources much more fairly. and thus generations of un-underwritten loans and businesses that lost out to “high-leverage bet the house” businesses. Just carry out the implications of natural selection with leverage vs without. ultimately economics is about best resource allocation and it is doomed to fail if there’s high leverage in the system. I think one can only justify debt for educational purposes and even then with demand pricing, ivy leagues, medical schools, and law schools can burden people with crippling amounts of debt. The sad truth is that information asymmetry creates this problem. Most people don’t run the #’s to see if some types of education even make sense financially. That’s just simply not how things should be.

    Alex Golubev

    19 Feb 10 at 10:12 am

  13. Alex – Leveraged strategies outcompete other strategies if the environment is “stable”. This is essentially Minsky’s theory that stability breeds instability. I would rephrase this as “stability breeds loss of resilience” which is a core concept in ecology, especially in the research of C.S. Holling which I have referred to in earlier posts.

    If the stability and increased leverage arise endogenously, then the course of action is tricky. But much of our stability in the Great Moderation is a result of explicitly stabilising strategies followed by the Fed in particular. It sounds counterintuitive but small and frequent disturbances are the antidote against potential economic depressions. My earlier post on Knightian uncertainty touches on this briefly and I will be writing a lot more on this topic.

    admin

    19 Feb 10 at 10:29 am

  14. I agree, too big to fail is a huge problem. The best we can hope for is that JPM’s and BOA’s get broken up into smaller failable pieces. But something tells me that our banks don’t exist in a vacuum, so while this would be a giant first step, we would still have a lot more to make our systems more fair.

    First of all, too big to fail doesn’t apply to the actual agents, so natural selection still guarantees that certain executives will cash out on a 1-year frequency (through bonuses and some of their equity), while the population of retail investors will continously get replenished and end up holding the bag when the long term risk finally bears fruit. Wolves and sheep. Wolves aren’t evil for eating the sheep, but there is an element of unfairness if the rules of the game aren’t explained or explainable to the entire population. or maybe they are, but i would still argue that information asymmetry creates a fundamental unfairness problem. you may enjoy this paper showing that dishonesty/bluffing is the best evolutionary policy:
    http://emergentfool.com/2009/09/24/dishonesty-is-the-best-policy/

    (i’m not trying to argue against any of your points. i just think the conclusions reach way beyond big banks)

    Alex Golubev

    19 Feb 10 at 10:57 am

  15. That’s an interesting paper – Thanks!

    As you’ve argued, we have enough problems as it is. My frustrations are directed at how many of our current problems, especially those pertaining to the current crisis, are entirely avoidable institutional errors that make things a lot worse than they otherwise would be.

    admin

    19 Feb 10 at 11:33 am

  16. […] If our best economists knew in 1993, in a widely published article that bankruptcy for profit could occur when government guarantees a firm’s debt obligations, why is it that the U.S. government continue to guarantee debt obligations?  Indeed, not only it continued the guarantees, but it expanded them –  by means of numerous actions supported by both Democratic and Republican Congressmen expanded the scale of its debt obligations through the deliberate growth of Fannie Mae and Freddie Mac.  And note that bankruptcy for profit is merely the most extreme case of moral hazard due to government guarantees; there are plenty of deep moral hazard issues due to government guarantees that could lead to similarly catastrophic outcomes well before we get to the case of outright looters.   (See both Roberts and Macroeconomic Resilience, a brilliant anonymous blogger he cites; see the analysis here,here, and here). […]

  17. […] addition he frequently points out the problems of moral hazard and fundamental problems with our financial systems causes obtuse payouts for finance sectors and […]

  18. […] and rigid solutions rather than adaptable and flexible solutions. This may be a consequence of moral hazard or principal-agent problems as I have analysed many times on this blog but it does not depend on […]

  19. […] my previous post, I explained how a moral hazard outcome can come out even in the absence of explicit agent […]

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