Sunday, February 15, 2009

Risk Part 6: Moral Hazard

Moral hazard occurs when someone is in a position to take risks that can hurt other people, but that can only result in benefit to the risk-taker.

In our current financial environment, there are several causes of moral hazard:

* Bonuses to investment dealers - Traders invest other people's money, and they suffer no penalty for losing money. They are paid huge bonuses (sometimes as high as 20 to 50%) for showing short-term gains on their investments. This encourages them to invest recklessly - to look for high short-term returns, regardless of long-term problems.
* Layered leverage without transparency - There is a large group of players who benefit from the upside of investments but pass the downside on. These include the mortgage originator, underwriter, and mortgage pool sponsor; and the traders of credit default swaps, collateralized debt obligations and collateralized mortgage obligations.
* Government bailouts - Bailouts mean, essentially, that profit is privatized while risk is socialized.
* Sinecure - Senior management has become an elite group that looks out for itself, regardless of performance. Not only are management bonuses insufficiently tied to company performance, but CEOs who fail in one place are generally able to find similar work elsewhere.

The bad bonus system is not all the fault of the banks. When hedge funds started paying 20% bonuses they started attracting all the best traders, which pretty well forced the banks to increase bonuses.

There are lots of good suggestions for how to change trader incentive by reducing and restructuring bonuses. There's no question those need to be implemented.

But it doesn't help to incentivize the traders to think long-term if the bosses aren't thinking long-term. In fact, a lot of the current criticism smacks of scapegoating. After all, those bonuses got set up because it benefited the guys at the top, and it's at the top that the buck really stops. Currently, the organizational incentive is to push short-term profits at all costs - even at the cost of the company collapsing.

The problem goes beyond reckless investments; problems with over-leveraging and insufficient capital are just as bad, if not worse. By the time of the collapse last fall entire companies were precarious houses of cards that were doomed to collapse when the bubble burst. Worse, the only reason we didn't know it was going to happen was because of insufficient transparency. And all of this was in a heavily regulated, heavily scrutinized industry.

What we need to do is remove, or at least reduce, moral hazard throughout the financial industry. That means we need to go beyond capital requirements and leverage limits and address the root of the problem. People and organizations who have the priviledge of investing money should have to prove their ability to act responsibly. There should be serious jail time for people who take reckless risks. That would be a start.

See also:
See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard
Risk Part 7: Some Basic Accounting Problems


1 comment:

Anonymous said...

Nice article. Your analysis of the moral hazard problem is spot on, and if the financial world is to rebuild itself and have long term stability, then moral hazard must be eliminated from the businesses.