In my previous post, I explained how a moral hazard outcome can come out even in the absence of explicit agent intentionality to take on more risk. This post will focus on the practical implications of the moral hazard problem in banking. Much of the below is just a restatement of arguments made in my first post that I felt needed to be highlighted. For references and empirical evidence, please refer to the earlier post.
Moral hazard can persist even if the bailout is uncertain. Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. The implication is that there is no partial solution of the moral hazard problem. There must be a credible and time-consistent commitment that under no circumstances will there even be a partial creditor bailout.
In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt issued is issued at less than its true economic cost, it adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.
Increased leverage and a riskier asset portfolio are not substitutable. Most moral hazard explanations of the crisis claim that the implicit/explicit creditor protection from deposit insurance and the TBTF doctrine causes banks to “take on more risk”, risk being defined as a combination of higher leverage and a riskier asset portfolio. The above arguments show that risk taken on via increased leverage is distinctly superior to the choice of a riskier asset portfolio – Unlike increased leverage, riskier assets do not include any free lunch component.
Regulatory capital requirements force banks to choose from a continuum of choices with low leverage and risky assets combinations on one side to high leverage and “safe” assets on the other (This argument assumes that off balance sheet vehicles cannot fully remove the regulatory capital constraint). Given that high leverage maximises the moral hazard subsidy, banks are biased to move towards the high leverage, “low risk” combination. The frequent divergence between market risk-reward and ratings-implied risk-reward of course means that riskier assets will still be invested in. But they need to clear a higher hurdle than AAA assets.
High-powered incentives encourage managers/traders to operate under high leverage. Bonuses and equity compensation help align the interests of the owner and the manager.
Risk from an agent’s perspective is defined by the skewness of asset returns as well as the volatility. Managers/Traders are motivated to minimise the probability of a negative outcome i.e. maximise negative skew. This tendency is exacerbated in the presence of high-powered incentives. Andrew Lo illustrated this in his example of the Capital Decimation Partners in the context of hedge funds (Hedge fund investors of course do not have an incentive to maximise leverage without limit).
The above is a short explanation of the consequences of moral hazard that explains the key facts of the crisis – high leverage combined with an apparently safe asset portfolio of AAA assets such as super-senior tranches of ABS CDOs. Contrary to conventional wisdom, a moral hazard outcome is characterised by negatively skewed bets, not volatile bets.
The dominance of negatively skewed bets means that it is extremely difficult to detect the outcome of moral hazard by statistical methods. As Nassim Taleb explains here, a large sample size is essential. If the analysis is limited to a “calm” period, the mean as well as the variance of the distribution will be significantly misestimated. Moreover, the problem is exacerbated if one has assumed a symmetric distribution as is often the case. The “low measured variance” is easily misunderstood as a refutation of the moral hazard outcome rather than the confirmation it really represents.