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.
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.
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.