Saturday, April 10, 2010

moral hazard cashed out

This objection errs in assuming that the moral hazard problem requires an explicit intention on the part of economic agents to take on more risk and maximise the free lunch available courtesy of the taxpayer. The essential idea which I outlined at the end of this post is as follows: The current regime of explicit and implicit bank creditor protection and regulatory capital requirements means that a highly levered balance sheet invested in “safe” assets with severely negatively skewed payoffs is the optimal strategy to maximise the moral hazard free lunch. Reaching this optimum does not require explicit intentionality on the part of economic actors. The same may be achieved via a Hayekian spontaneous order of agents reacting to local incentives or even more generally through “natural selection”-like mechanisms.

Let us analyse the “natural selection” argument a little further. If we assume that there is a sufficient diversity of balance-sheet strategies being followed by various bank CEOs, those CEOs who follow the above-mentioned strategy of high leverage and assets with severely negatively skewed payoffs will be “selected” by their shareholders over other competing CEOs. As I have explained in more detail in this post, the cheap leverage afforded by the creditor guarantee means that this strategy can be levered up to achieve extremely high rates of return. Even better, the assets will most likely not suffer any loss in the extended stable period before a financial crisis. The principal, in this case the bank shareholder, will most likely mistake the returns to be genuine alpha rather than the severe blowup risk trade it truly represents. The same analysis applies to all levels of the principal-agent relationship in banks where an asymmetric information problem exists.

Self-Deception and Natural Selection

But this argument still leaves one empirical question unanswered – given that such a free lunch is on offer, why don’t we see more examples of active and intentional exploitation of the moral hazard subsidy? In other words, why do most bankers seem to be true believers like Tannin and Cioffi. To answer this question, we need to take the natural selection analogy a little further. In the evolutionary race between true believers and knowing deceivers, who wins?
Between a CEO who is consciously trying to maximise the free lunch and a CEO who genuinely believes that a highly levered balance sheet of “safe” assets is the best strategy, who is likely to be more convincing to his shareholders and regulator? Bob Trivers’ work shows that it is the latter. Bankers who drink their own Kool-Aid are more likely to convince their bosses, shareholders or regulators that there is nothing to worry about.

Macroeconomic Resilience on Natural Selection, Self-Deception and the Moral Hazard Explanation of the Financial Crisis, the rest here.

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