Not only is it questionable public policy to use taxpayer money to bail out private companies, but, more important, it creates a moral hazard: the incentive for those companies to take excessive risks with the knowledge that the government will save them should things go wrong. Of course, the plan backfired completely. The chaos that ensued forced the government to step in to protect almost every financial instrument involved in the credit markets, from money market funds to commercial paper to asset-backed securities, and to ride to the rescue of some of America’s largest banks.
In the process, the government created moral hazard on an epic scale, transforming a vague expectation that certain financial institutions were “too big to fail” into a virtual government guarantee. Moral hazard already existed in the system on at least three levels. First, bank employees and managers had asymmetric compensation structures. In good years, they stood to make huge amounts of money; in bad years, even if the bank lost money, they would still make healthy sums. This gave employees the incentive to take excessive risks because they could shift their potential losses to shareholders.
Second, shareholders had the same payoff structure. Banks are highly leveraged institutions; every dollar contributed by shareholders is magnified by 10 to 30 dollars from creditors. This meant that in good years, shareholders benefited from profits that were juiced by leverage, but should things go wrong, they could shift their potential losses to creditors. As a result, paying bank executives in stock did not mitigate their behavior; in fact, the most senior executives at both Bear Stearns and Lehman had and lost enormous amounts of money tied up in their companies.
Third, creditors had only limited incentives to watch over major banks. Ordinarily, creditors should demand high interest rates on loans to highly leveraged institutions. However, the expectation that large banks would not be allowed to fail made creditors more willing to lend to them. This is why the failure of Lehman was such a damaging blow: It shattered market expectations that the government would not let a major bank fail. “No more Lehmans” — which has made the implicit government guarantee stronger than ever before.
So while the decision to let Lehman fail was a mistake, rescuing Lehman would not have prevented the financial crisis; most likely it would have only reduced the degree of panic and the amount of collateral damage to the global economy. If the Obama administration is serious about preventing a future financial crisis, it will have to address these three forms of moral hazard. However, its proposals may not be adequate to the task.
The proposed solutions to skewed compensation structures are “say on pay” and increased independence of board compensation committees. However, at best this ensures that managers have the same incentives as shareholders — which they already do for the most part. These reforms do not address the problem that shareholders like the fact that banks are highly leveraged institutions. Another approach to limiting moral hazard is giving the government resolution authority” for large financial institutions, similar to the FDIC’s power to shut down commercial banks.
This would theoretically give the government the ability to wind down a bank in an orderly fashion while imposing “haircuts” on creditors; this would, in turn, give creditors the incentive to watch more closely over their borrowers. Resolution authority carries a meaningful threat only if market participants believe the government would actually use it in a way that harms shareholders and creditors . . . and the government has just spent months insisting that harming either shareholders or creditors is a mistake.
Treasury Department has also proposed tightening capital requirements on large banks, which could make it harder for them to borrow large amounts of money. But this would do little to change the incentives at work; it would at best reduce the amount of damage that a bank could cause on the way down. If moral hazard cannot be effectively minimized, then the alternative solution is stricter regulation. The government would have the power to simply demand that they do the right thing We may find ourselves attempting to contain moral hazard, on a trial-and-error basis, for years to come.