Moral Hazard: A Necessary Price to Pay for Stakeholder Responsibility

The current liquidity crisis centered in the American financial system but which has extended its cancerous tentacles as well out to global financial institutions has led to knowledgeable commentators reflecting on the problem of “moral hazard”.

Is it wise, some ask, to provide relief from the consequences of their actions for those who created too much risk?

Recently, the case of Bear Sterns, the New York investment bank at the center of the sub-prime/CDO bubble – brought concerns for creating “moral hazard” to the fore.

To prevent the bankruptcy of Bear Sterns and defaults on its many borrowings and guarantees, which would have spread losses to many other financial institutions, the US Federal Reserve System with support from the US Treasury arranged easy terms for Bear Sterns to be purchased by another concern so that Bear Sterns’ business and obligations could go forward in some form of a going concern basis.

The Federal Reserve System – the American lender of last resort – took bad assets from Bear Sterns in exchange for a loan to buy the firm. If the Bear assets prove to be worth something in the future, the cost to the public for this intervention will not be so much.

The owners of Bear Sterns were paid at first US$2 and then US$10 per share for equity worth $80 per share in book value. They were so forced to absorb great capital loss as a result of their company’s imprudent business activities.

Nonetheless, the reformatting of Bear Sterns’ business set a precedent that, in the future, incautious investment banking practices will again be coddled by the government and not given a market death sentence as was the case with Enron. This act of public interference with market discipline, it is said, creates “moral hazard” – the hazard that business decision-making will be more “immoral” or irresponsible than otherwise because the decision-makers will have less fear of the consequences of their actions.

Creating moral hazard implies that businesses will be careless about the risks they create or assume.

Coming as part of the sub-prime mortgage meltdown where the mortgage loans of many sub-prime borrowers will be foreclosed and the borrowers will lose their homes, the government’s financial support for the well-to-do on Wall Street while providing no help for the poor was not well-received in many parts of society. The financial elite was indulged with tolerance of moral hazard while the poor were left to bear all on their own the consequences of their imprudent borrowing.

Market discipline is good enough for some but too tough for others it appears.

Under Treasury Secretary Paulsen’s proposal for revised regulation of American financial markets, investment banks will be invited to use the lending capacity of the Federal Reserve System. This will give the originators of the most sophisticated and most sought-after financial instruments deep pocket support in times of crisis – crises no doubt brought about by the very practices of creating investment vehicles now to be given a kind of fiscal insurance by the government.

Why should the government, that is the people, reward mistakes in judgment with indulgence and protection against extreme outcomes? This will only encourage weak character in senior business leaders who will be more likely as a result to let their greed take the reins of business strategy, to lower quality standards, and to become more childishly naïve about risk. Moral hazard promotes infantile fixation on the short term where adult maturity should have pride of place in decision-making.

The free market, with its powers of creative destruction, its weeding out of the weak, the overly greedy, the stupid, and the careless, has its own high standards of morality. Failure is punished harshly and there are few second acts for companies that can’t make the grade. Why not let the market dish out the consequences in all cases? All should get to sleep in the beds they make.

The justification for indulging in moral hazard is to eliminate contagion in financial systems. Financial systems turn on trust; credit is a gossamer thing, easily broken and lost. The so-called real economy of production and distribution is more tangible, with hard assets to support restructuring of ownership and creditor interests when things go badly. With financial services, however, protecting the intangible assets of trust and confidence keeps liquidity flowing so that industry and commerce can have their necessary flows of credit and cash on a daily basis.

Contagion in the financial system is a danger to all in a way that is not implicated so much when an individual home owner defaults on a mortgage or when an Enron or a WorldCom goes bankrupt.

The logic at work here in justifying indulgence in moral hazard is stakeholder thinking, akin to the ethical rational for corporate social responsibility.

When stakeholder interests are taken into account, good decision-making moves beyond pure market rationality narrowly defined in only micro-economic terms. When stakeholders are included in business decision-making, assets of a more intangible nature are added on to tangible ones in the calculation of risk and return.

Adding stakeholder considerations to the decision-making matrix moves more towards a system theory understanding of the economy, where tangible and intangible feed-back loops intertwine and crisscross one with another.

Thus, it would be very appropriate in the case of a Bear Sterns market failure to worry about contagion – the impact of one firm’s demise on many who have interests in the play of market forces.

It is only another example of the problem of externalities – who should pay the cost of consequences that are external to the firm’s profit and loss statement and its balance sheet?

In most cases, it is society that pays in one way or another – for environmental damage, for health problems of consumers or employees, for unemployment compensation when companies close down, etc.

So it would seem consistent with wider practices to have society, in the form of the Federal Reserve System that passes its costs on to all in the economy, step up and attempt to minimize the harm flowing from bad decisions on Wall Street.

The problem of moral hazard arises whenever we insure against the negative consequences of our conduct. When we spread the cost of our externalities widely through insurance policies, we create moral hazard by reducing the full measure of punishment on those whose actions produce the loss or harm.

By removing the onus of paying the “last full measure” of careful consideration from their shoulders, we encourage people through insurance programs to feel that they are less at risk themselves, So they may conveniently take greater risk with respect to the lives and fortunes of others.

Insurance, externalities, and moral hazard combine to form a rather intricate puzzle for optimizing market outcomes.

To reduce negative externalities, we want to bring the consequences of actions back on the actors. But they may not be in a position to make good on the harm they have created, so we need insurance to protect the interests of stakeholders who have no say in the decisions that affect them. But with such insurance, we open the doors to moral hazard.

In any case, society seems consistently to take the stakeholder perspective into account through its laws and regulatory practices and so runs the risk of allowing too much moral hazard.

The point would seem to be that markets turn on more than the stand-alone profit and loss accounts of firms and individuals, but are forced willy-nilly by the powers that create and sustain them to take account of intangible stakeholder concerns even at the cost of indulging in moral hazard.