Moral Hazard

There has been a lot of discussion lately about moral hazard. This is the idea that if people get rescued when doing risky things they will be more inclined to do them in the future, as will others who see the results.

Moral hazard has become a popular topic in financial circles of late as financial firms get bailed out by central banks when their risky behavior goes wrong. The argument given to defend this rescue is that not doing so would drag others down as well.

I have two problems with the moral hazard argument when applied to businesses.

The first problem is that letting people fail now does not create a lesson for them in the future. When a child burns themselves on a hot stove they learn a lesson that they will remember. When a trader engages in some risky behavior, it is unlikely that this will be the same individual 30 years from now who repeats the activity. People learn from mistakes, institutions don't. Institutions "learn" by having rules and regulations created which incorporate the lessons from the past. This is the institutional memory. Those who are in favor of fewer regulations are not doing future generations any favors.

The second problem is that there is a separation between those taking the risk and those suffering the consequences. In the earliest days of capitalist enterprise owners bore all the risk of failure. Seventeenth and eighteenth Century English literature is filled with stories of men "ruined" when their business failed. To pay off their creditors they had to sell all their possessions and many times go into debtor's prison.

An innovation was the creation of the limited liability company where only the assets of the firm could be seized to pay debts, not those of the stockholders. This innovation made it much easier for owners to raise capital from others since the most they would risk was their original investment. At this point the first disconnect occurred. As time went on, it became apparent that most firms could not continue to be run by their founders or heirs. The enterprises became too big, or there were no suitable family members to take over. Companies brought in a new class of workers - professional managers. The disconnect was now complete.

Managers had no stake in the firm, they got their compensation for the job they did, not how well they did it. The problem with this model soon became apparent and a variety of techniques were devised to deal with this. The most common have been to tie (part) of the compensation to the company's performance. This is usually in the form of a performance bonus. Another popular technique is to award stock options to the managers under the theory that a successful firm will see its stock price go up and the managers will be able to cash in their options at a profit. It is also a low cost way for the firm since if the options aren't cashed in it costs the firm nothing.

Just as the firms saw the benefits of these new compensation schemes, so did the managers and they also saw the shortcomings. Tying options to stock price shifted the goals of managers from improving the behavior of the firm to manipulating the stock price. Lately this has gotten so out of hand that when the options fail to yield a profit the firms replace them with cheaper ones, so that even the indirect incentive to do well is removed. Salary compensation schemes have also been corrupted so that managers now get big payouts regardless of how the firm does. Wall Street calls these golden handshakes and golden parachutes.

There is one level of control available beyond compensation to control the risky behavior of managers, this is the possibility of criminal prosecution if their activity is not just risky, but illegal. This possibility has been effectively eliminated over the past several decades. The number of top managers who have been convicted of a crime and sent to prison is so small that it presents no deterrent. When illegal behavior is uncovered the firms usually pay a fine and promise not to repeat the behavior in the future. The managers suffer no consequences, in fact most don't even lose their jobs. The fine is paid by the stockholders, not the managers, as a subtraction from profits.

Now there are many investors these days who have lost large sums of money as the more risky financial schemes unwind. These people didn't devise the schemes, they just invested in them. Those who made the fees selling these instruments didn't take the risk, they had no incentive to behave prudently. This is as true for those buying structured investment vehicles as for poor, misinformed homeowners. This is another example of the separation of risk from reward. Moral hazard has no relevance.

If moral hazard is to mean anything then the separation between those taking the risks and those getting the rewards has to be removed. In addition law breaking has to be punished at the personal, not institutional level. Firms don't break laws, people do.

Lastly, the lessons learned from prior mistakes need to be codified in regulations. Moral hazard is eliminated by more regulation, not less. If a firm can't make a profit playing by the rules, then it shouldn't be in business. If it gets away with things then it forces other firms to break the rules as well in order to compete. This is not commerce it is corruption.

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Copyright © 2008 Robert D Feinman
Feel free to use the ideas, but the words are mine.