It seems to me that despite all that has happened to the world's financial markets and economies, little has been done to address moral hazard. Moral hazard remains the biggest risk to stability and recovery, and continues to run unchecked. Call me a hopeless optimist, but I was hoping that the US Congress at least would grow some balls and push out sensible regulatory reform. And then I thought, maybe no one really understands just what moral hazard means. Maybe the powers-that-be believe that "the markets" can sort themselves out, and let the buyer beware. So I thought a little primer might be in order to try and educate our politicians about the beast known as "the financial markets". (As I shamelessly cadge the For Dummies style, I beg the brilliant and totally cool Wiley Publishing not to sue me.)
Moral Hazard for Dummies
Understanding Moral Hazard - Moral hazard is what happens when someone (let's say a trader) who is insulated from risk behaves differently than he would if he were fully exposed to the risk. In other words, he believes that his short-term bonus will be bigger if he takes on a larger long-term risk. He tells himself that he will probably be working for another bank by the time he is rumbled anyway (i.e. when the longer-term risk fails to pay off). He has nothing to lose personally, and everything to gain.
Making Moral Hazard Simple
Derivatives trader - I just sold an unbelievably complicated interest rate swap to some idiot in Umbria. She thinks it will save her town from having to shut down schools and turn off the power. What she doesn't understand is that in order to keep from having to pay me off when it goes wrong, she has to keep paying me off. Win/win! It looks fabo on my P&L. (Anyway, what does Umbria need with electricity? The hospitals probably have generators, right?)
Oil trader - Obama is really getting hot under the collar about Iran's nuclear program. The authorities are leaning on us to stop selling them gasoline. But the margins are terrific. John -you like the beach, right? Take the next flight to Dubai and open me a little shell office. We can use that to keep selling gasoline to Iran and no one will be the wiser! A little bizzo in the morning and the rest of the day to sun yourself!
Executive of a bank - Our share price still sucks and the Board meeting is coming up next week. I can't live on a dollar a year for much longer, I need a new carriage house. George, what can we do to make people think we have recovered from the downturn? Never mind the mortgage write-downs, those are for next year! Have corp comms leak it to the press that we are sitting on a mountain of cash and that we might institute a share buyback program.
Do's of Moral Hazard
- Do regulate derivatives - beyond central clearing and making them trade on exchanges. They should NOT be a "buyer beware" product.
- Do regulate banks the Volcker way - take away prop trading, hedge funds and private equity.An instant reduction in temptation and moral hazard.
- Do monitor oil markets - they are getting away with murder because you can't be arsed to upset the oil lobby.
- Don't leave the banks to make their own rules.