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Moral hazard and too big to fail

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Moral hazard and too big to fail

As the debates continue regarding how to reform the financial systems, “too big to fail” and “moral hazard” repeatedly come up in these debates. The basic argument goes as follows: if financial institutions are allowed to become too big so that the market expects government to bail them out, then government is creating a moral hazard which will lead to even greater risk taking by management. According to this argument, senior executives are presented with “heads I win, tails you lose” options, as long as their companies are large enough, and this will encourage them to place even bigger and more risky bets.

But these problems are exaggerated. It is not the size of financial institutions that matters. It is the complexity of their operations – the number and opaqueness of their tentacles throughout the global financial system.

Long Term Capital Management (LTCM) was not a particularly large hedge fund when it failed and was propped up by several of the major central banks, including the U.S. Federal Reserve. Rather, intervention was necessitated by the complexity of its contractual dealings, and the uncertainty regarding the potential fallout on the global financial system if it failed and had to immediately liquidate its positions. No one really knew at that time what might have happened if LTCM was simply allowed to fail. Central bankers did fear that the consequences might be devastating despite the relatively small size of LTCM.

Lehman was allowed to fail because the U.S. Treasury had become very sensitive to the argument that it was creating a very serious moral hazard by bailing out Bear Stearns and other large financial institutions. Lehman was not the largest financial institution prior to its death in September 2008. It might not even have ranked among the largest 25 in the world. However, after Lehman was allowed to die, global financial markets froze because of the uncertainty created by the sudden reversal in Treasury’s behavior, and the even greater uncertainty created for pricing of financial assets and risk because of the myriad inter-relationships between Lehman and most major financial companies around the world.

The U.S. Treasury was blind sided by the complexity of Lehman’s operations and the degree of interdependence in the financial markets. There was no picture available, even for the regulators. Treasury quickly learned the ramifications of allowing a company such as Lehman to fail. That is why it moved so quickly to bail out AIG and others.

The lack of transparency, combined with complexity, are the major problems, not size per se. Going back to the world of Glass-Steagall would lessen the complexity for banks; and mandating that all financial transactions, including those involving exotic derivatives, be conducted on exchanges would clear away much of the opaqueness, and enable regulators to develop a picture of the inter-relationships.

The moral hazard argument is also very specious. The “bailout” of Bear Stearns provided the impetus for the critics. The bailouts following the collapse of Lehman amplified the chorus and resulted in even stronger warnings of moral hazard. Many believed that moral hazard could be prevented only if the large financial companies were effectively nationalized – the Gordon Brown solution.

Shareholders in Bear Stearns and most other financial companies, which received financial support in one form or another, lost most of the value of their investments in these companies at that time. There isn’t much difference for investors in going from a 90% loss to a 100% loss as advocated by the proponents of nationalization. There is no moral hazard for shareholders.

The CEOs of most of these companies did lose their jobs and much of their wealth. Hence, there isn’t a moral hazard for executives. Moreover, their inclination, if any, to take greater risks should be constrained by their directors and creditors, if not by regulators.

Bondholders also took a haircut, although perhaps, not as large as they could have. Thus, if a moral hazard is created, it might be only for certain classes of creditors.

Moral hazard is not a rampant problem. Indeed, it is not likely to be an important problem with future bailouts. Opaqueness, complexity and inter-dependence are much more serious problems, and most discussions of reforming the financial system seem to overlook these problems.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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