Moral Hazard and the Survival Value of Risk
Also published by United Press International (UPI)
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Written May 2002
Updated June 2005
Risk transfer is the gist of modern economies. Citizens pay taxes to ever expanding governments in return for a variety of "safety nets" and state-sponsored insurance schemes. Taxes can, therefore, be safely described as insurance premiums paid by the citizenry. Firms extract from consumers a markup above their costs to compensate them for their business risks.
Profits can be easily cast as the premiums a firm charges for the risks it assumes on behalf of its customers - i.e., risk transfer charges. Depositors charge banks and lenders charge borrowers interest, partly to compensate for the hazards of lending - such as the default risk. Shareholders expect above "normal" - that is, risk-free - returns on their investments in stocks. These are supposed to offset trading liquidity, issuer insolvency, and market volatility risks.
The reallocation and transfer of risk are booming industries. Governments, capital markets, banks, and insurance companies have all entered the fray with ever-evolving financial instruments. Pundits praise the virtues of the commodification and trading of risk. It allows entrepreneurs to assume more of it, banks to get rid of it, and traders to hedge against it. Modern risk exchanges liberated Western economies from the tyranny of the uncertain - they enthuse.
But this is precisely the peril of these new developments. They mass manufacture moral hazard. They remove the only immutable incentive to succeed - market discipline and business failure. They undermine the very fundaments of capitalism: prices as signals, transmission channels, risk and reward, opportunity cost. Risk reallocation, risk transfer, and risk trading create an artificial universe in which synthetic contracts replace real ones and third party and moral hazards replace business risks.
Moral hazard is the risk that the behaviour of an economic player will change as a result of the alleviation of real or perceived potential costs. It has often been claimed that IMF bailouts, in the wake of financial crises - in Mexico, Brazil, Asia, and Turkey, to mention but a few - created moral hazard.
Governments are willing to act imprudently, safe in the knowledge that the IMF is a lender of last resort, which is often steered by geopolitical considerations, rather than merely economic ones. Creditors are more willing to lend and at lower rates, reassured by the IMF's default-staving safety net. Conversely, the IMF's refusal to assist Russia in 1998 and Argentina in 2002 - should reduce moral hazard.
The IMF, of course, denies this. In a paper titled "IMF Financing and Moral Hazard", published June 2001, the authors - Timothy Lane and Steven Phillips, two senior IMF economists - state:
"... In order to make the case for abolishing or drastically overhauling the IMF, one must show ... that the moral hazard generated by the availability of IMF financing overshadows any potentially beneficial effects in mitigating crises ... Despite many assertions in policy discussions that moral hazard is a major cause of financial crises, there has been astonishingly little effort to provide empirical support for this belief."
Yet, no one knows how to measure moral hazard. In an efficient market, interest rate spreads on bonds reflect all the information available to investors, not merely the existence of moral hazard. Market reaction is often delayed, partial, or distorted by subsequent developments.
Moreover, charges of "moral hazard" are frequently ill-informed and haphazard. Even the venerable Wall Street Journal fell in this fashionable trap. It labeled the Long Term Capital Management (LTCM) 1998 salvage - "$3.5 billion worth of moral hazard". Yet, no public money was used to rescue the sinking hedge fund and investors lost most of their capital when the new lenders took over 90 percent of LTCM's equity.
In an inflationary turn of phrase, "moral hazard" is now taken to encompass anti-cyclical measures, such as interest rates cuts. The Fed - and its mythical Chairman, Alan Greenspan - stand accused of bailing out the bloated stock market by engaging in an uncontrolled spree of interest rates reductions.
In a September 2001 paper titled "Moral Hazard and the US Stock Market", the authors - Marcus Miller, Paul Weller, and Lei Zhang, all respected academics - accuse the Fed of creating a "Greenspan Put". In a scathing commentary, they write:
"The risk premium in the US stock market has fallen far below its historic level ... (It may have been) reduced by one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk ... This insurance - referred to as the Greenspan Put - (involves) exaggerated faith in the stabilizing power of Mr. Greenspan."
Moral hazard infringes upon both transparency and accountability. It is never explicit or known in advance. It is always arbitrary, or subject to political and geopolitical considerations. Thus, it serves to increase uncertainty rather than decrease it. And by protecting private investors and creditors from the outcomes of their errors and misjudgments - it undermines the concept of liability.
The recurrent rescues of Mexico - following its systemic crises in 1976, 1982, 1988, and 1994 - are textbook examples of moral hazard. The Cato Institute called them, in a 1995 Policy Analysis paper, "palliatives" which create "perverse incentives" with regards to what it considers to be misguided Mexican public policies - such as refusing to float the peso.
Still, it can be convincingly argued that the problem of moral hazard is most acute in the private sector. Sovereigns can always inflate their way out of domestic debt. Private foreign creditors implicitly assume multilateral bailouts and endless rescheduling when lending to TBTF or TITF ("too big or too important to fail") countries. The debt of many sovereign borrowers, therefore, is immune to terminal default.
Not so with private debtors. In remarks made by Gary Stern, President of the Federal Reserve Bank of Minneapolis, to the 35th Annual Conference on Bank Structure and Competition, on May 1999, he said:
"I propose combining market signals of risk with the best aspects of current regulation to help mitigate the moral hazard problem that is most acute with our largest banks ... The actual regulatory and legal changes introduced over the period-although positive steps-are inadequate to address the safety net's perversion of the risk/return trade-off."
This observation is truer now than ever. Mass-consolidation in the banking sector, mergers with non-banking financial intermediaries (such as insurance companies), and the introduction of credit derivatives and other financial innovations - make the issue of moral hazard all the more pressing.
Consider deposit insurance, provided by virtually every government in the world. It allows the banks to pay to depositors interest rates which do not reflect the banks' inherent riskiness. As the costs of their liabilities decline to unrealistic levels -banks misprice their assets as well. They end up charging borrowers the wrong interest rates or, more common, financing risky projects.
Badly managed banks pay higher premiums to secure federal deposit insurance. But this disincentive is woefully inadequate and disproportionate to the enormous benefits reaped by virtue of having a safety net. Stern dismisses this approach:
"The ability of regulators to contain moral hazard directly is limited. Moral hazard results when economic agents do not bear the marginal costs of their actions. Regulatory reforms can alter marginal costs but they accomplish this task through very crude and often exploitable tactics. There should be limited confidence that regulation and supervision will lead to bank closures before institutions become insolvent. In particular, reliance on lagging regulatory measures, restrictive regulatory and legal norms, and the ability of banks to quickly alter their risk profile have often resulted in costly failures."
Stern concludes his remarks by repeating the age-old advice: caveat emptor. Let depositors and creditors suffer losses. This will enhance their propensity to discipline market players. They are also likely to become more selective and invest in assets which conform to their risk aversion.
Both outcomes are highly dubious. Private sector creditors and depositors have little leverage over delinquent debtors or banks. When Russia - and trigger happy Russian firms - defaulted on their obligations in 1998, even the largest lenders, such as the EBRD, were unable to recover their credits and investments.
The defrauded depositors of BCCI are still chasing the assets of the defunct bank as well as litigating against the Bank of England for allegedly having failed to supervise it. Discipline imposed by depositors and creditors often results in a "run on the bank" - or in bankruptcy. The presumed ability of stakeholders to discipline risky enterprises, hazardous financial institutions, and profligate sovereigns is fallacious.
Asset selection within a well balanced and diversified portfolio is also a bit of a daydream. Information - even in the most regulated and liquid markets - is partial, distorted, manipulative, and lagging. Insiders collude to monopolize it and obtain a "first mover" advantage.
Intricate nets of patronage exclude the vast majority of shareholders and co-opt ostensible checks and balances - such as auditors, legislators, and regulators. Enough to mention Enron and its accountants, the formerly much vaunted firm, Arthur Andersen.
Established economic theory - pioneered by Merton in 1977 - shows that, counterintuitively, the closer a bank is to insolvency, the more inclined it is to risky lending. Nobuhiko Hibara of Columbia University demonstrated this effect convincingly in the Japanese banking system in his November 2001 draft paper titled "What Happens in Banking Crises - Credit Crunch vs. Moral Hazard".
Last but by no means least, as opposed to oft-reiterated wisdom - the markets have no memory. Russia has egregiously defaulted on its sovereign debt a few times in the last 100 years. Only seven years ago - in 1998 - it thumbed its nose with relish at tearful foreign funds, banks, and investors. Six years later, President Vladimir Putin dismantled Yukos, the indigenous oil giant and confiscated its assets, in stark contravention of the property rights of its shareholders.
Yet, Russia is besieged by investment banks and a horde of lenders begging it to borrow at concessionary rates. The same goes for Mexico, Argentina, China, Nigeria, Thailand, other countries, and the accident-prone banking system in almost every corner of the globe.
In many places, international aid constitutes the bulk of foreign currency inflows. It is severely tainted by moral hazard. In a paper titled "Aid, Conditionality and Moral Hazard", written by Paul Mosley and John Hudson, and presented at the Royal Economic Society's 1998 Annual Conference, the authors wrote:
"Empirical evidence on the effectiveness of both overseas aid and the 'conditionality' employed by donors to increase its leverage suggests disappointing results over the past thirty years ... The reason for both failures is the same: the risk or 'moral hazard' that aid will be used to replace domestic investment or adjustment efforts, as the case may be, rather than supplementing such efforts."
In a May 2001 paper, tellingly titled "Does the World Bank Cause Moral Hazard and Political Business Cycles?" authored by Axel Dreher of Mannheim University, he responds in the affirmative:
"Net flows (of World Bank lending) are higher prior to elections ... It is shown that a country's rate of monetary expansion and its government budget deficit (are) higher the more loans it receives ... Moreover, the budget deficit is shown to be larger the higher the interest rate subsidy offered by the (World) Bank."
Thus, the antidote to moral hazard is not this legendary beast in the capitalistic menagerie, market discipline. Nor is it regulation. Nobel Prize winner Joseph Stiglitz, Thomas Hellman, and Kevin Murdock concluded in their 1998 paper - "Liberalization, Moral Hazard in Banking, and Prudential Regulation":
"We find that using capital requirements in an economy with freely determined deposit rates yields ... inefficient outcomes. With deposit insurance, freely determined deposit rates undermine prudent bank behavior. To induce a bank to choose to make prudent investments, the bank must have sufficient franchise value at risk ... Capital requirements also have a perverse effect of increasing the bank's cost structure, harming the franchise value of the bank ... Even in an economy where the government can credibly commit not to offer deposit insurance, the moral hazard problem still may not disappear."
Moral hazard must be balanced, in the real world, against more ominous and present threats, such as contagion and systemic collapse. Clearly, some moral hazard is inevitable if the alternative is another Great Depression. Moreover, most people prefer to incur the cost of moral hazard. They regard it as an insurance premium.
Depositors would like to know that their deposits are safe or reimbursable. Investors would like to mitigate some of the risk by shifting it to the state. The unemployed would like to get their benefits regularly. Bankers would like to lend more daringly. Governments would like to maintain the stability of their financial systems.
The common interest is overwhelming - and moral hazard seems to be a small price to pay. It is surprising how little abused these safety nets are - as Stephane Pallage and Christian Zimmerman of the Center for Research on Economic Fluctuations and Employment in the University of Quebec note in their paper "Moral Hazard and Optimal Unemployment Insurance".
Martin Gaynor, Deborah Haas-Wilson, and William Vogt, cast in doubt the very notion of "abuse" as a result of moral hazard in their NBER paper titled "Are Invisible Hands Good Hands?":
"Moral hazard due to health insurance leads to excess consumption, therefore it is not obvious that competition is second best optimal. Intuitively, it seems that imperfect competition in the healthcare market may constrain this moral hazard by increasing prices. We show that this intuition cannot be correct if insurance markets are competitive.
A competitive insurance market will always produce a contract that leaves consumers at least as well off under lower prices as under higher prices. Thus, imperfect competition in healthcare markets can not have efficiency enhancing effects if the only distortion is due to moral hazard."
Whether regulation and supervision - of firms, banks, countries, accountants, and other market players - should be privatized or subjected to other market forces - as suggested by the likes of Bert Ely of Ely & Company in the Fall 1999 issue of "The Independent Review" - is still debated and debatable. With governments, central banks, or the IMF as lenders and insurer of last resort - there is little counterparty risk. Or so investors and bondholders believed until Argentina thumbed its nose at them in 2003-5 and got away with it.
Private counterparties are a whole different ballgame. They are loth and slow to pay. Dismayed creditors have learned this lesson in Russia in 1998. Investors in derivatives get acquainted with it in the 2001-2 Enron affair. Mr. Silverstein was agonizingly introduced to it in his dealings with insurance companies over the September 11 World Trade Center terrorist attacks.
We may more narrowly define moral hazard as the outcome of asymmetric information - and thus as the result of the rational conflicts between stakeholders (e.g., between shareholders and managers, or between "principals" and "agents"). This modern, narrow definition has the advantage of focusing our moral outrage upon the culprits - rather than, indiscriminately, upon both villains and victims.
The shareholders and employees of Enron may be entitled to some kind of safety net - but not so its managers. Laws - and social norms - that protect the latter at the expense of the former, should be altered post haste. The government of a country bankrupted by irresponsible economic policies should be ousted - its hapless citizens may deserve financial succor. This distinction between perpetrator and prey is essential.
The insurance industry has developed a myriad ways to cope with moral hazard. Co-insurance, investigating fraudulent claims, deductibles, and incentives to reduce claims are all effective. The residual cost of moral hazard is spread among the insured in the form of higher premiums. No reason not to emulate these stalwart risk traders. They bet their existence of their ability to minimize moral hazard - and hitherto, most of them have been successful.
Note on Regulation
Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint - the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.
The state would, therefore, do well to regulate all financial instruments: deposits, derivatives, contracts, loans, mortgages, and all other deeds that are exchanged or traded, whether publicly (in an exchange) or privately. Trading in a new financial instrument should be allowed only after it was submitted for review to the appropriate regulatory authority; a specific risk model was constructed; and reserve requirements were established and applied to all the players in the financial services industry, whether they are banks or other types of intermediaries.
Note on Risk Aversion
Why are the young less risk-averse than the old?
One standard explanation is that youngsters have less to lose. Their elders have accumulated property, raised a family, and invested in a career and a home. Hence their reluctance to jeopardize it all.
But, surely, the young have a lot to forfeit: their entire future, to start with. Time has money-value, as we all know. Why doesn't it factor into the risk calculus of young people?
It does. Young people have more time at their disposal in which to learn from their mistakes. In other words, they have a longer horizon and, thus, an exponentially extended ability to recoup losses and make amends.
Older people are aware of the handicap of their own mortality. They place a higher value on time (their temporal utility function is different), which reflects its scarcity. They also avoid risk because they may not have the time to recover from an erroneous and disastrous gamble.
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