Tuesday, September 16, 2008

Moral Hazard for Corporations

With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. (Well, a “recommendation” after the fact is known as a “criticism,” but I would have recommended the same thing before the fact. The main reason I didn’t talk about it before the fact is that I expected officials to do what I would have recommended anyhow.) Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

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Anonymous Jim Glass said...

"But what if there were no deposit insurance and the same risky actions were taken?"

I am running the Casino Savings & Loan. In a world of 3% interest rates on deposits I offer 7%.

Prospective depositors reply: "Who are you kidding? I don't need the smarts of a Lehman investment banker to know you are taking some sort of crazy risk with my money to pay 7%! "

I tell them: "Your deposits are 100% guaranteed by the federal govt! Under that new law, you know. So what's the risk I'm taking to you?"

They say: "Well, if you put it that way, OK, sure. Here's our $X million, and give us that 7%!"

So I take the money, and as a top-owner exec of CS&L provide myself a merit-based compensation package that pays me the big bucks, based on the huge deposits I'm drawing in and the high investement returns produced by my proudly "aggressive and innovative" investment strategy. And as the share price of my now "growth stock" S&L shoots way up, I cash some of my shares out and deposit others in my secure-forever Keogh and 401(k) retirement plans, where I swap them tax-free for S&P 500 index shares.

(Very possibly I sell out on top right there, having made a name for myself as a "star banker" forever. Thereafter you watch me on Charlie Rose opining about periodic banking crises. )

A few years later market conditions turn, my innovative investment strategy blows up (my card counters get kicked out of the casino), and CS&L goes bust.

If I'm still running it I'm a bit chagrined but walk away still plenty rich enough on the money I've put away, and immune from liability on my common shares (those I still own) -- having done not a thing that was illegal. And the FDIC gets stuck with $X of deposit liabilities it has to pay off. All because of the risky investments I could never have made but for the deposit insurance that drew the extra $X of deposits to me.

A true story writ many times over during the great S&L boom and bust.

Create a free lunch opportunity for borrowers and you create a free lunch opportunity that lenders and their equity owner can game for profit too -- through taking riskier actions -- every time.

That's why these things have to be done with care, and with the tradeoffs full in mind.

Sat Sep 20, 06:24:00 PM EDT  
Blogger knzn said...

You're saying that "the same risky actions" could not have been taken in the first place if there were no deposit insurance, and that is of course true. But a counterfactual hypothesis ("if...the same risky actions were taken") does not have to be one that represents an actual possibility. Deposit insurance allows those actions to be taken, not by the way it affects stockholders or managers directly, but by the way it affects depositors and the consequent way in which depositors' behavior affects stockholders or managers. The insurance is not creating a moral hazard for stockholders; it is creating a moral hazard for depositors, and the stockholders' and managers' actions are being affected by the consequent behavior of the depositors.

Certainly the equity owners and managers can game the system, but only because their depositors have no incentive to police them or to exercise prudence in their selection. There is no moral hazard problem with respect to the owners and managers, except the ones that always exist with corporations. The problem is not that the owners and managers have a special moral hazard created by deposit insurance but that they lack oversight to prevent them from taking advantage of the moral hazard that they already had.

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Anonymous Anonymous said...

I tell them: "Your deposits are 100% guaranteed by the federal govt!
Under that new law, you know. So what's the risk I'm taking to you?"

Mon Aug 24, 10:45:00 AM EDT  
Anonymous Anonymous said...

And as the share price of my now "growth stock" S&L shoots way up, I cash some of my shares out and
deposit others in my secure-forever Keogh and 401(k) retirement plans, where I swap them tax-free for S&P 500 index shares.

Mon Aug 24, 10:46:00 AM EDT  
Anonymous Anonymous said...

The insurance is not creating a moral hazard for stockholders; it is creating a moral hazard for
depositors, and the stockholders' and managers' actions are being affected by the consequent behavior of the depositors.

Mon Aug 24, 10:46:00 AM EDT  
Anonymous Anonymous said...

A true story writ many times over
during the great S&L boom and bust.

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