22 September 2022

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The damages of moral hazard

Luigi Campopiano

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The 2008 crisis can still teach us a lot about the damage of moral hazard. And on the tools to prevent it. What can we say we have learned from the subprime mortgage crisis? It is very difficult to say because the lessons learned to vary significantly according to the narrative of the crisis itself.

The most widespread one centers on the idea of the "perfect storm" hitting the global economy against which financial engineers are fighting to keep the boat battered by the waves of events afloat. A more accurate narrative would start from how the same financial engineers, the Secretary of the Treasury, the Chairman of the Federal Reserve, and the Chairman of the Federal Reserve Bank of New York, decided to address (March 2008) investment bank crisis. Bear Stearns (not a “too big to fail” colossus, he was in agony for some time and close to bankruptcy).

The financial authorities saw behind that eventual bankruptcy the risk of a systemic crisis that could have dragged many other banks to the bottom. Hence, they decide to intervene to protect creditors. In the perception of the markets, from that moment on, even medium-sized banks become “too big to fail,” and thus, the expectations of future bailouts increase. After just six months, Lehman Brothers filed for bankruptcy. Why is Bearn Stearns bailed out with public funds and Lehman Brothers left to fail? According to many, this cannot be the real question. The real question: why was it chosen to save Bearn Stearns since this would have generated expectations of impunity in the management of financial institutions and induced even more unscrupulous behavior? This would have fomented what economists call "moral hazard".

Focusing on the Lehman episode as a trigger of the financial crisis leads to misrepresenting the chain of relevant events, neglecting the role played by the political choices that preceded that single event, and exaggerating the consequences because it is known that public coverage alters personal choices. If the government protects savers in any case, they have no reason to look for those who finance safer projects among potential intermediaries (so there is always, at worst, the state's safety net). This distortion of incentives falls into the category of moral hazard, but it is a much more general problem. The opportunistic behavior enacted by many private financial institutions in the aftermath of the Bearn Stearns bailout is just one striking example of a well-known inefficiency observed in markets and organizations when information is distributed asymmetrically.

Another form of inefficiency always linked to information asymmetry is adverse selection. It can occur when one of the parties involved in a transaction has private information about the characteristics of a good, a service, or a person. In these cases, the logic of adverse selection displaces the best characteristics, favoring the establishment of the worst ones. The case of moral hazard is similar to that of adverse selection because, in both cases, we speak of the root of inefficiency. Just as adverse selection determines the implosion of markets, so moral hazard hinders relationships and contracts that could prove advantageous for all parties involved.

Moral hazard differs from adverse selection because while the confidential information concerns the characteristics of a good or a person in the first case, in the second, it has to do with actions. We have:

• "Hidden characteristics." When a situation is characterized by private information on the characteristics, it is called "ex-ante asymmetry." In these cases, the non-observability or non-verifiability of the quality precedes the stipulation of a possible contract;

• "Hidden actions." In the case of private information on the shares, we speak of "ex-post asymmetry" because the non-observability or non-verifiability occurs after the signing of the contract.

In these cases, the information asymmetry and the interests that are not always perfectly aligned between the parties produce particular forms of inefficiencies. But, after all, we are all exposed to the risk of moral hazard because, by definition, the agent is chosen for his specialist knowledge, and the boss can never hope to completely control his choices. In a complex society, we can only delegate specialist tasks to specialists whose work we can only verify in a highly imperfect way. The risk of moral hazard is pervasive and profound, often endemic.

The information economy has studied and developed many useful tools to mitigate, if not solve, the harmful consequences of this problem, with the awareness that it is often possible to find a way out of information problems but to follow these paths. Exit always involves a cost.

If, as early as 2008, or perhaps even earlier, FED officials had firmly decided not to pass personal losses on to the taxpayer, they could have used some of the resources available to encourage other financial institutions to take on Bear Stearns' debt positions. The financial system would not have suffered decisive setbacks, and the Fed could have cushioned the blow linked to the failure of Bear Stearns by avoiding the sale of assets at undervalued prices. Public resources would have been necessary to fill the hole opened in the financial intermediaries' balance sheets by mortgage losses. Still, politics would have been invested before the responsibility of decisions, without the need to leave an enormous room of discretion to technicians without any democratic legitimacy.

Such conduct would have established an important precedent that could have produced long-term benefits in terms of stability precisely by reducing the risk of moral hazard on the part of financial institutions rendered unscrupulous by the impossibility of bankruptcy and consequent impunity. The failure of Bear Stearns could have been a credible signal of the commitment of public institutions against overly casual practices.

The lesson we can draw from this is that while rescuing troubled banks almost always seems like the best option when the decision is made, the same choices can set the stage for long-lasting effects that are far more damaging than their costs. Immediate. When information asymmetries draw scenarios like these, the results will never be optimal (first best), but we will have to be satisfied, at best, with the least bad (second-best). You have to accept Shakespeare's wise adage: “I don't know how far your eyes see. Looking for the best, we often spoil the good ”.