Moral Hazard and Agent Intentionality

A common objection to the moral hazard explanation of the financial crisis is the following: Bankers did not explicitly factor in the possibility of being bailed out. In fact, they genuinely believed that their firms could not possibly collapse under any circumstances. For example, Megan McArdle says: "I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong.  The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout." And Jeffrey Friedman has this to say about the actions of Ralph Cioffi and Matthew Tannin, the managers of the Bear Stearns fund whose collapse was the canary in the coal mine for the crisis: "These are not the words, nor were Tannin and Cioffi’s actions the behavior, of people who had deliberately taken what they knew to be excessive risks. If Tannin and Cioffi were guilty of anything, it was the mistake of believing the triple-A ratings."

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? The work of Robert Trivers on the evolutionary biology of self-deception tells us that the true believer has a significant advantage in this contest.

Trivers' work is well summarised by Ramachandran: "According to Trivers, there are many occasions when a person needs to deceive someone else. Unfortunately, it is difficult to do this convincingly since one usually gives the lie away through subtle cues, such as facial expressions and tone of voice. Trivers proposed, therefore, that maybe the best way to lie to others is to first lie to yourself. Self-deception, according to Trivers, may have evolved specifically for this purpose, i.e. you lie to yourself in order to enable you to more effectively deceive others." Or as Conor Oberst put it more succinctly here: "I am the first one I deceive. If I can make myself believe, the rest is easy." Trivers' work is not as relevant for the true believers as it is for the knowing deceivers. It shows that active deception is an extremely hard task to pull off especially when attempted in competition with a true believer who is operating with the same strategy as the deceiver.

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. Given a sufficiently strong selective mechanism such as the principal-agent relationship, it is inevitable that such bankers would end up being the norm rather than the exception. The real deviation from the moral hazard explanation would be if it were any other way!

There is another question which although not necessary for the above analysis to hold is still intriguing: How and why do people transform into true believers? Of course we can assume a purely selective environment where a small population of true believers merely outcompete the rest. But we can do better. There is ample evidence from many fields of study that we tend to cling onto our beliefs even in the face of contradictory pieces of information. Only after the anomalous information crosses a significant threshold do we revise our beliefs. For a neurological explanation of this phenomenon, the aforementioned paper by V.S. Ramachandran analyses how and why patients with right hemisphere strokes vehemently deny their paralysis with the aid of numerous self-deceiving defence mechanisms.

Jeffrey Friedman's analysis of how Cioffi and Tannin clung to their beliefs in the face of mounting evidence to the contrary until the "threshold" was cleared and they finally threw in the towel is a perfect example of this phenomenon. In Ramachandran's words, "At any given moment in our waking lives, our brains are flooded with a bewildering variety of sensory inputs, all of which have to be incorporated into a coherent perspective based on what stored memories already tell us is true about ourselves and the world. In order to act, the brain must have some way of selecting from this superabundance of detail and ordering it into a consistent 'belief system', a story that makes sense of the available evidence. When something doesn't quite fit the script, however, you very rarely tear up the entire story and start from scratch. What you do, instead, is to deny or confabulate in order to make the information fit the big picture. Far from being maladaptive, such everyday defense mechanisms keep the brain from being hounded into directionless indecision by the 'combinational explosion' of possible stories that might be written from the material available to the senses." However, once a threshold is passed, the brain finds a way to revise the model completely. Ramachandran's analysis also provides a neurological explanation for Thomas Kuhn's phases of science where the "normal" period is overturned once anomalies accumulate beyond a threshold. It also provides further backing for the thesis that we follow simple rules and heuristics in the face of significant uncertainty which I discussed here.

Fix The System, Don't Blame the Individuals

The "selection" argument provides the rationale for how the the extraction of the moral hazard subsidy can be maximised despite the lack of any active deception on the part of economic agents. Therefore, as I have asserted before, we need to fix the system rather than blaming the individuals. This does not mean that we should not pursue those guilty of fraud. But merely pursuing instances of fraud without fixing the incentive system in place will get us nowhere.


David Merkel

I knew a high yield bond manager who said to me when I was new to institutional investing. "This is a lousy company, but their debt has a sweet YTNJ." I thought I knew most acronyms in bonds, but this one eluded me. "YTNJ?" He grinned and said, "Yield to next job." Oddly, he is still in that job today, and doing well.

Aléa moral et sélection naturelle « Rationalité Limitée

[...] Est-ce que cela invalide la thèse de l’aléa moral ? Non, si l’on en croit ce très intéressant billet sur le blog « Macroeconomic [...]

Recomendaciones « intelib

[...] Natural Selection, Self-Deception and the Moral Hazard Explanation of the Financial Crisis [...]

Michael F. Martin

Nice post. There is some evidence that one can correct for the tendency of individuals to subvert the interests of their group through modification of the selective pressure. To some extent, however, it appears that the size of the group and the time horizons for the competition are mutually exclusive constraints.


Thanks David - I hadn't heard that acronym either! But it does ring true. Shifting potential losses into the future is a popular strategy for many agents, not least politicians - Greece probably being the best example.


Thanks Michael - your idea in the linked post of better disclosure mitigating the principal-agent problem is valid. At the very least, we need to enforce strict mark-to-market in as many cases as we can - a point I have argued in an earlier post.

Ken Houghton

And Jeffrey Friedman has this to say about the actions of Ralph Cioffi and Matthew Tannin..."If Tannin and Cioffi were guilty of anything, it was the mistake of believing the triple-A ratings.” (Adds Jeffrey Friedman to list of people who should never be allowed to write about finance again, except with the small Crayola box.)


I clicked though to your linked refs; fascinating reading. Although I swear Trivers was getting paid by the word; he takes forever to get to the point. However, in quoting Trivers via Ramachandran you really might mention that Ramachandran thinks Trivers is, if not wrong, not entirely right, either. Moreover, claiming Ramachandran provides a neurological explanation for Kuhnian paradigm shifts is over the edge. In the first place, I spent about three years of my life studying those issues, coming to the conclusion that, on the whole, the less said about Kuhnian paradigm shifts the better. More directly, Ramachandran's work would lead one to believe that after a certain point scientists should shift paradigms. In fact, as Kuhn documents, what happens is that the new paradigm wins when believers in the old one die off. It's the young, who have less invested in the old way, who make the shift. See "Night Thoughts of a Classical Physicist." I should add that I agree with your main point; several lines of argument show that the assumption of deliberate exploitation of the value of the implicit government guarantee is not necessary to explain that guarantee's role in the mess.

Jed Harris

Your points are excellent. They have a broad implication. If people have any systematic deviations from rationality, the economic system will evolve to exploit those deficits until stopped by breakdown or regulation. So for example credit card and rental car insurance exploit risk aversion, pay day loans exploit hyperbolic discounting, etc. Markets adapt to amplify irrationality.


Student - in fairness to Trivers, I linked to his collection of papers in which he collated all his work organised by theme. I'm sure he has made his point more briefly in earlier works! You're right. I thought of mentioning Ramachandran's critique of Trivers but decided against it because I wasn't leaning on a strict interpretation of Trivers' conclusion. As Ramachandran mentions, self-deception has maladaptive consequences. But its not clear to me that the true believer banker is engaging in true self-deception given that he benefits in the short run. As I see it, the conclusion is more relevant for the knowing deceiver who has an uphill task competing with a true believer. But yes - I think Ramachandran's paper especially is fascinating reading and very well-written and accessible. On Kuhn again you're right. My point was only that Ramachandran gives us a neurological basis for the inflexibility of the old guard even if they are being entirely sincere. And I'm glad you agree with the central point!

Natural selection, self-deception and the moral hazard explanation of the crisis - Viewsflow

[...] Bankers didn't need to consciously envision a bailout to be subject to moral hazard: bankers just needed to deceive themselves about the risks they were taking.Close [...]

Does Majoritarian Democracy Systematically Result in Moral Hazard and Financial Industry Irresponsibility? « Let A Thousand Nations Bloom

[...] If our best economists knew in 1993, in a widely published article that bankruptcy for profit could occur when government guarantees a firm’s debt obligations, why is it that the U.S. government continue to guarantee debt obligations?  Indeed, not only it continued the guarantees, but it expanded them –  by means of numerous actions supported by both Democratic and Republican Congressmen expanded the scale of its debt obligations through the deliberate growth of Fannie Mae and Freddie Mac.  And note that bankruptcy for profit is merely the most extreme case of moral hazard due to government guarantees; there are plenty of deep moral hazard issues due to government guarantees that could lead to similarly catastrophic outcomes well before we get to the case of outright looters.   (See both Roberts and Macroeconomic Resilience, a brilliant anonymous blogger he cites; see the analysis here,here, and here). [...]

Rafe Furst

Good article. You might check out the work on Common Knowledge vs Mutual Knowledge as it helps explain these sorts of complex regimes. Also "implicit collusion" in poker tournaments.


Rafe - Thanks for the references.

Inequality and Moral Hazard Rents in the Financial Sector at Macroeconomic Resilience

[...] or even via selection mechanisms arising from principal-agent dynamics – Indeed I have argued that active deception on the part of economic agents is unlikely to be selected for. All of which [...]