Martin Wolf clearly worries about moral hazard:

It is desirable that institutions are prevented from exploiting explicit and implicit guarantees in order to make speculative investments of little economic benefit. The spectacle of businesses prospering from activities from whose consequences they have had to be rescued and from whose impact the public is still suffering is distressing.

But others claim moral hazard is not the major issue:

the moral hazard explanation for what went wrong doesn’t really hold much water. In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in.

Wolf concedes that some of Obama’s ideas are not workable:

Would it really be possible to draw and, more importantly, police a line between legitimate activities of banks and activities “unrelated to serving their customers”? If institutions were encouraged to lend to customers, would they be allowed to securitise and sell those loans? Would they be allowed to hedge the risks of lending? If not, why not? If yes, when does this become speculation?

And Economics of Contempt can easily find reasons that capping bank size is a bad idea:

Now imagine that we cap bank size at, say, $100bn in assets. What happens if a bank with $99bn in assets fails? The way the FDIC resolves failed banks smoothly is through P&As, but the only banks big enough to buy the $99bn failed bank would surely be over the $100bn cap if they agreed to the purchase. So the choice is effectively between (1) a disorderly liquidation by the FDIC, which would pose exactly the kind of systemic risks that proponents of capping bank size are trying to avoid; or (2) granting an acquiring bank (or banks) a waiver from the $100bn cap and proceeding with a P&A.

And, as my recent post on Shadow Banking has (I hope) demonstrated, a shadow banking system using bonds or other vehicles can achieve many of the same things as banking  – but may fall beyond the realm of ordinary regulation.  Does this matter?  If such entities can always fail, then perhaps not.  Not enough has been said on this topic.  I personally would rather see less attention aimed at the features of individual institutions, and more at the system as a whole.

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5 thoughts on “Some paragraphs to ponder

  1. “the moral hazard explanation for what went wrong doesn’t really hold much water…”

    This reasoning in this second quotation seems flawed to me, because it fails to distinguish between the owners, the managers, and the bondholders of a firm. The logic applies fairly well to the first owners, but not the other groups. Managers with a small stake quite possibly *did* know that their actions were reckless, but were unafraid of the consequences as long as they never had to pay back their salaries or bonuses. Meanwhile, the knowledge that there would be a government bailout in the event of failure persuaded the bondholders to lend to the firms cheaply enough that the managers could go on with their recklessness.

    I’m with Martin.

    1. I think your point about bonds is very sound. Why the LT lenders of money to banks have not had a worse time is quite extraordinary. I myself have benefited from this – buying Barclays bonds at 44 in Feb, now worth 90 – and I can appreciate how unfair it is.

      Niklas, I intend to read that Haldane Speech, alongside the Sentance one. Already snowed, first day back from work.

      But Sean, I don’t agree that the managers knew how reckless things were. None had any idea that this was on the radar. Pride, the perception that they are clever and wise, is a big part of their motivation. Most of them would have found this a life-ruining experience, regardless of the money they carted away

      1. Ok, suppose that the managers of Lehman, RBC, HBOS, etc., have found this to be a life-ruining experience, now that things have turned out badly for them.

        That still doesn’t necessarily refute the idea that they were knowingly reckless.

        For example, they may have known that the markets would turn out either “well” or “badly”, and that they could either behave “prudently” or “recklessly”. Suppose that if they behave prudently, then they do reasonably well no matter what happens to the market. If they behave recklessly, then they do very nicely if markets turn out well, but they lose the firm if markets turn out badly.

        To the extent that bondholders are receiving implicit insurance from the central bank, it becomes less costly for the managers to behave recklessly. Other things being equal, the managers are more likely to be reckless (they’ve got free insurance, after all).

        Importantly, this is true even though the managers may regret behaving recklessly after the markets have gone badly.

        It’s like any moral hazard problem: houses may imprudently be built in a flood plain because of implicit government insurance, even though the owners will regret their purchase in the event of a flood. People buy the houses because there might not be a flood, and then they’ll have gotten free (albeit partial) insurance.

        The crucial consideration is that whenever somebody gets subsidized insurance, they have an incentive to behave more recklessly. If the insurance is partial, then they may still regret the recklessness ex post, but that doesn’t mean that it was anything other than recklessness (from a social perspective) ex ante.

        But, then again, I don’t actually know many bankers. You may be right.

      2. I think you have forced me to be more nuanced, which I ought to have been before. I agree that bankers (a) have asymmetric payoffs, (b) know this and (c) that (b) affected their behaviour which led to (d) all sorts of mayhem and misery.

        BUT I don’t necessarily hold with the view that the source of (a) was all government insurance, except in the sense that we don’t execute bankers, 14th Century Florence style, any more. As a result, there are several layers of asymmetry even before you get to the systemic bailout level. You have employees able to walk away from failing firms; shareholders getting upside but limited downside; share options, and so on. I suspect that the one they DIDN’T think of was “government rescuing us”. I think this may even apply to bondholders. If you are an employee at a bond fund, then your incentive is heavily tied to what happens in 2 years, not what happens in 5.

        I strongly agree your emphasis on decisions once things have gone wrong. Then, though, the trouble was that everyone was begging the financially strong to come in and buy risky bonds and equity. We had very divided motivations: should we make things really difficult for people brave enough to buy in autumn 2008? Because if we do, then in future noone ever steps up to do private sector rescues in such circs.

  2. I’m also with Martin. Andy Haldane’s paper (that I linked to in the comments to your excellent shadow banking post) provides strong backup for Mr Wolf’s view on moral hazard. Certainly the money and capital markets were lending far too freely to some precarious banks (step forward the Icelandic banks, for example), no doubt thinking that their risks were limited.

    Haldane’s point is that relatively thin capital cushions and limited liability, combined with state guarantees for deposits, mean that downside risks are artificially truncated for bank owners: they can only lose what they put in, but their gains are potentially infinite. Guaranteed deposits mean that the taxpayer has to step in to cover much of the cost of any bank failure. As I said, Haldane’s paper is definitely worth reading.

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