In my previous post, I explained how a moral hazard outcome can come out even in the absence of explicit agent intentionality to take on more risk. This post will focus on the practical implications of the moral hazard problem in banking. Much of the below is just a restatement of arguments made in my first post that I felt needed to be highlighted. For references and empirical evidence, please refer to the earlier post.

Moral hazard can persist even if the bailout is uncertain. Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. The implication is that there is no partial solution of the moral hazard problem. There must be a credible and time-consistent commitment that under no circumstances will there even be a partial creditor bailout.

In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt issued is issued at less than its true economic cost, it adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.

Increased leverage and a riskier asset portfolio are not substitutable. Most moral hazard explanations of the crisis claim that the implicit/explicit creditor protection from deposit insurance and the TBTF doctrine causes banks to "take on more risk", risk being defined as a combination of higher leverage and a riskier asset portfolio. The above arguments show that risk taken on via increased leverage is distinctly superior to the choice of a riskier asset portfolio - Unlike increased leverage, riskier assets do not include any free lunch component.

Regulatory capital requirements force banks to choose from a continuum of choices with low leverage and risky assets combinations on one side to high leverage and "safe" assets on the other (This argument assumes that off balance sheet vehicles cannot fully remove the regulatory capital constraint). Given that high leverage maximises the moral hazard subsidy, banks are biased to move towards the high leverage, "low risk" combination. The frequent divergence between market risk-reward and ratings-implied risk-reward of course means that riskier assets will still be invested in. But they need to clear a higher hurdle than AAA assets.

High-powered incentives encourage managers/traders to operate under high leverage. Bonuses and equity compensation help align the interests of the owner and the manager.

Risk from an agent's perspective is defined by the skewness of asset returns as well as the volatility. Managers/Traders are motivated to minimise the probability of a negative outcome i.e. maximise negative skew. This tendency is exacerbated in the presence of high-powered incentives. Andrew Lo illustrated this in his example of the Capital Decimation Partners in the context of hedge funds (Hedge fund investors of course do not have an incentive to maximise leverage without limit).

The above is a short explanation of the consequences of moral hazard that explains the key facts of the crisis - high leverage combined with an apparently safe asset portfolio of AAA assets such as super-senior tranches of ABS CDOs. Contrary to conventional wisdom, a moral hazard outcome is characterised by negatively skewed bets, not volatile bets.

The dominance of negatively skewed bets means that it is extremely difficult to detect the outcome of moral hazard by statistical methods. As Nassim Taleb explains here, a large sample size is essential. If the analysis is limited to a "calm" period, the mean as well as the variance of the distribution will be significantly misestimated. Moreover, the problem is exacerbated if one has assumed a symmetric distribution as is often the case. The "low measured variance" is easily misunderstood as a refutation of the moral hazard outcome rather than the confirmation it really represents.

Comments

The implications of moral hazard in banking - Viewsflow

[...] A clear, concise and illuminating explanation of how moral hazard operated in the run-up to the crisis.Close [...]

Sean

From a (ex-) practitioner's point of view, I can confirm your models expectations in reality. Indeed for all the talk of 'toxic' assets the real damage was all about extraordinary leverage blowing up banks with relatively small (initial) declines in decent assets generating catastrophic results. See my take on Northern Rock from Sept 2007 for example: http://www.parkparadigm.com/2007/09/21/on-leverage-and-fraggle-northern-rock/

admin

Thanks Sean. All of my models are derived from the reality I perceive and I'm glad it corresponds to your perceptions as well!

Bootvis

Financial theory says that rational investors should prefer positive skewness. This is proven under some weak assumptions in "On The Direction of Preference for Moments of Higher Order Than The Variance" by Scott and Horvath (1980) (I can only find it on jstor, behind a wall :(). What's your view on this descrepancy?

Sean

Some really interesting writing - but not much on the about page! Adding Macroresilience to my RSS reader but if you are on twitter, that's where I spend more time (harvesting information) now. (Which is how I stumbled across this post.)

admin

Bootvis - I only contend that agents in a principal-agent relationship aim to maximise negative skewness. In this case, the principal can be seen as the owner of a bank and the agent is the manager or trader. Asymmetric information being the prime driver, exacerbated by high-powered incentives. The issue of whether investors who are not agents prefer negative skewness or positive skewness is a much trickier question and deserves a separate post which I'm working on and hopefully will post in the next few days.

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