Moral hazard has been around as a term since 1865, but after the Global Financial Crisis and more recent U.S. bank failures its dangers are now in the forefront of all investors’ minds. We held the first of two Linchpin Salon panel debates on the subject on 3rd May 2023. There was a record attendance, and our panel, moderated by Aoifinn Devitt, consisted of:
Gerard Fox, Chair, East Sussex Pension Fund Committee
Con Keating, Head of Research at BrightonRock
Pete Drewienkiewicz, Chief Investment Officer, Global Assets at Redington
Grainne Dooley, Independent Non-Executive Director/Chair
Jonathan Hollow, Writer and Author on Consumer Education and Protection
Moral hazard today is caused by the activity of states
Our first task was to define what we mean by moral hazard. We looked at its early history in the private insurance business, where individuals benefited from fraudulent behaviour such as arson, while insurance companies in turn faced adverse selection risk, which were in those days termed moral hazards. The original mitigation was through the use of deductibles (i.e., the insured party pays the first part of any loss) to align interest, but these have faded away.
Today it is predominantly driven by sovereign states’ behaviour as the insurer of last resort. In providing guarantees they remove the need for buyers to do any due diligence on risky investments. We settled on a definition that moral hazard is where the gain accrues to the risk-taker, but losses fall on somebody else.
Moral hazard today takes the form of a general mentality that Government will act as a back-stop to any risk-taking behaviour which goes wrong. The burden of this falls on taxpayers, though one view is that, priced appropriately, the cost should be neutral in the long-term. The problem in recent years has been the frequency of events needing bail-outs in some form. A core root of this today consists in the economic or financial imbalances in the world.
QE and leverage are the first line root causes
Some of the panel placed the blame on Quantitative Easing (QE), others thought the issue was more one of excessive leverage and behind that weak regulation. One panellist pointed out that the fractional banking system embedded financial imbalances into the system, as all banks depend on maintaining confidence. Once it goes, they go, as we saw with Credit Suisse.
The 2008 U.S. savings and loans crisis was used as an example of weak regulation, as it was largely caused by a relaxation in lending standards with the worthy aim of trying to make access to mortgages more inclusive. The panel wondered whether the tightening of bank regulations after the Global Financial Crisis had simply moved moral hazard to other financial activities such as investments and pensions.
We discussed how greed drives moral hazard. For example, Silicon Valley Bank’s investments in higher yielding bonds was down to the desire for higher returns. If they had a Chief Risk Officer in place, which they didn’t, they might have behaved differently. We noted that greed is the main driver of excessive leverage, as for example in private equity. Unlike exogenous risk, this endogenous risk could be removed by regulators, but we did not think this constituted moral hazard as such without some form of bail-out. In this context, we noted that partnerships often behaved better than companies.
Pension funds and moral hazard?
We then discussed the LDI crisis in the U.K. and whether the Government’s provision of liquidity created moral hazard, or indeed did any good. The panel thought the answer was negative to both questions. Whilst the pensioners were effectively bailed out, they were not the guilty actors. There was no gain from the bail-out to other parties, except to cap any further losses.
Ultimately the trustees and advisers were primarily responsible, though we felt that trustees were too inclined to try and pass the blame onto their advisers. We asked whether there was any sanction and concluded that generally, while they don’t go to prison, that there are consequences for incompetent trustees.
We also discussed the Pension Protection Fund’s activities. Again, we felt this did not constitute moral hazard for the same reason that the pensioners were not the guilty parties and should not be subject to a hair-cut on their pensions. However, there is a clear moral hazard issue around Directors who deliberately dump their pension liabilities onto the PPF.
How to mitigate moral hazard
We then looked at how the authorities might regulate to mitigate the risk of moral hazard. One angle was to regulate leverage as that quickly removes endogenous risk. Others thought the problem was more to do with the eligibility of collateral required. Banks must put up cash or government bonds, but insurance companies are allowed to use corporate bonds. Easier collateral requirements might have the effect of reducing liquidity issues.
An alternative suggestion was to insure all bank and savings current accounts fully. By removing the risk of losing money, there would be no reason for a bank run. The alternative view was that this would remove any incentive for consumers to distinguish the risk between banks; they would all go to the one offering the highest return, regardless of how risky the bank’s behaviour was.
It was pointed out that today’s behaviour has been different. Consumers are moving to mainstream banks despite lower returns precisely because they believe that there will be a penalty for taking excessive risk when depositing money. But if a government feels obliged to bail out all the deposit holders in the future, as happened with Silicon Valley Bank, then consumer behaviour may change.
More regulation is likely
The final comment was that there is a tendency for governments to get involved, partly because of the political problems but also because the politicians concerned probably will not be around to face the consequences of their actions. The panel thought that meant the next step would inevitably be a further round of regulation before governments reach for the magic money tree. The world will eventually regain some form of financial equilibrium, but the panel was pessimistic on the timescale for this.
In conclusion, moral hazard today is largely driven by the state’s behaviour, and the mitigation largely comes from the state. The question will be how much appetite politicians will have to regulate, and how effective will they be. In our next debate on 31st May we will look at the question from the perspective of investors rather than consumers, with a particular focus on ESG.
Bibliography etc
Link to London School of Economics Charles Goodhart lecture on 17th May 2023 by Professor Raghuram Rajan on Central Bank Balance Sheet Expansion and Financial Stability: why less can be more
Too Smart for our Own Good by Bruce I. Jacobs Published by McGraw-Hill Education ISBN: 9781260440546 available on Waterstones or Amazon