Regulate and don’t worry about moral hazard

September 17, 2009

By John M. Berry

The government bailouts of ailing financial institutions are gradually doing their job in helping markets right themselves. And all the worry that they have only encouraged financiers to take even greater risks in the future is badly misplaced.

The bailouts were undertaken in desperation in the wake of monumental failures of financial regulation. The Securities and Exchange Commission badly fumbled in overseeing investment banks, the Comptroller of the Currency did little better with federally chartered commercial banks, and the Federal Reserve failed to understand what bank holding companies were up to.

There are plenty of solid reasons to demand that Congress move ahead as quickly as possible with an overhaul of financial regulation. Yet that overhaul should not be focused as intensely as it has been on what to do about the institutions that are regarded as too big and too interconnected to be allowed to fail.

Some seem to believe that the existence of those institutions more or less caused the current crisis by creating moral hazard. That’s the notion that if managers know government won’t let their institution fail, they can freely place bets to make a killing knowing they are backstopped with taxpayer money.

Moral hazard was a major factor in the savings and loan crisis of the 1980s, which ended up costing the government about $150 billion. That was the case because thrift institutions operated almost entirely with government-insured deposits, and even insolvent ones could keep the money rolling in.

But this time around, the excessive risks were taken largely by big institutions financed by uninsured, managed liabilities, not so called retail deposits. The first to fall, Bear Stearns and Lehman Brothers, were investment banks with no insured deposits at all.

The moral hazard that was rampant before this crisis was altogether different. It was the skewed goals and compensation structure of the largest institutions that created the hazard.

Many executives were — and apparently still are — focused on enhancing the size of their annual bonuses. Generally the instruments they created, the deals they struck and the trades they executed were financed by their employers’ money. Their skin in the game was the size of their bonus, which routinely dwarfed their salary.

Furthermore, the full bonus or much of it is typically paid at year’s end or soon after, with any deferred portion distributed the following year. If a deal turned sour later, well, that was the institution’s problem, not for the wheeler-dealers on the front lines.

This kind of pay structure might be viable with tight management oversight, abundant capital and proper allocation to risk. Of course, we know that in most of the institutions such oversight was sorely lacking, with top executives and directors paying far more attention to keeping reported profits rising quarter after quarter.

Management, regulation and supervision all failed. In their place we ended up with bailouts and huge injections of cash into the money markets by the Fed.

Financial markets have healed sufficiently that the Obama administration is beginning to withdraw some of its financial aid and so is the Fed. That is entirely justified.

Has this tentative improvement increased moral hazard? Keep in mind that in the current crisis, even with the bailouts, the owners of the banks have lost their collective shirts — or nearly so.

Take Citigroup. Before the crisis hit, its shares were trading near $50. Yesterday they closed at $4.17, off 92 percent over two years. However, the loss has been even greater because 34 percent of the shares are now owned by the government as a result of capital infusions that prevented Citigroup’s bankruptcy.

So private shareholders have lost roughly 95 percent of their stake as a result of foolish risks taken by the bank’s managers.

Has moral hazard increased because equity holders weren’t entirely wiped out? I doubt it.

The focus should not be on the size of the institution, but on how well it is regulated.

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