Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

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. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).

The Regulator's Dilemma

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery.

If only it were that easy!

Imagine that you are the regulator in charge of the banking industry. What are your aims?

Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”.

On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors should withdraw their money from badly-run banks, and you don't want to stand in their way. You don't want to bail out the incompetent; that’s deeply unfair to the competent, and it messes up incentives all through the system. (To quote one famous investor, “Bailouts are bad morality as well as bad economics”).

Unfortunately, these two aims are fundamentally incompatible. Because smart bankers will simply pile into precisely those trades which pose systemic risks!

Why should a banker take the trouble to build a unique portfolio, thus exposing himself to all sorts of idiosyncratic risk factors? If these idiosyncratic factors go against him, he will appear (uniquely) stupid, and will probably not be bailed out. It’s much better for him to pile into the same trade as everyone else¹. Then if things go sour, it will be a systemic crisis and so everyone will be bailed out, including the banker in question.

(This insight is nothing new; it is merely the compensation dynamic for 1 trader on a desk of 10 traders, applied to 1 bank in an economy of 10 banks, with bailouts substituting for bonuses.)

In fact the situation is even more perverse than it appears. A standard measure of trade quality is the risk-reward ratio: the lower this ratio, the better the trade. But if systemic crises and consequently bailouts are in play, then the reasoning becomes inverted. Losses from low-risk trades are, by definition, small; hence low-risk traders are unlikely to be bailed out. Conversely, losses from high-risk trades are, by definition, large and potentially life-threatening; hence high-risk traders will often be backstopped by the government. This is moral hazard at its most pernicious.

It gets worse. The more enthusiastically people herd into one (systemically risky) trade, the higher the odds of a bailout; the higher the odds of a bailout for a particular trade, the more people will want to enter that trade. Yes, it’s our old friend, positive feedback!

So what’s a well-meaning regulator to do? There are only two coherent choices, really: put an end to bailouts, or put an end to bank proprietary trading.

Sadly, I don’t see either of these happening.

Footnotes

# ¹ Throughout this post I use ‘trades’ as a convenient short-hand for ‘institutional strategic decisions’.