Moral Hazard and Banking

What an odd day. Clearly all our statisticians are at the beach because there is no data release of any kind today. So we can all take a break from the stress of trying to figure out what the entrails mean and relax a little.

But wait.

The immediate danger of depression is behind us, and the recession is ending – it may already have ended – so now is a good time to begin the inquest and strategize over how to avoid a repeat of the ‘Great Recession’.

Let me begin by saying that I doubt we will avoid recessions. They are an inevitable part of the exuberance of capitalism. The Keynes/Minsky vision seems to be correct: confidence builds as growth is sustained; people inevitably become greedy and over-extend; eventually this over-extension leads to implosion and a cathartic cleansing of illusory wealth. Only for the cycle to begin again. This cyclicality matches up well with what Schumpeter saw as ‘gales of destruction’ being immanent within the capitalist system.

One of the illusions we have just had dispelled was that of academic economists. They thought their orthodox theory had developed such refinement that we could moderate and avoid severe cycles. And I know of very few mainstream economists who imagines otherwise: there was a general sense of self-satisfaction within the profession that we had the theories and tools to fend off major bumps in growth. The evidence of the past thirty years seemed to back that notion up. All that was needed, the orthodox argued, was to clean up the details.

Some details.

“The best way to contain the evils of moral hazard is to make it personal.”

It now turns out that Keynes and his followers were exactly correct: markets are inherently fallible. This fallibility stems from the natural, residual, uncertainty that is a permanent property of our world. There is nothing we can do to eliminate it. All we can hope for is to box it in and translate it into manageable risks.

And on the front lines of uncertainty we find the banks.

So as we set out to rebuild the dykes we must focus on the banking system.

Lost in all the hubbub over health care is the fact that we are facing a large scale overhaul of the way in which we regulate banking. In many ways this is the most important reform being discussed in Washington – failure to reform the banks will accelerate our momentum towards the next recession.

We all now know far too much about banking: the headlines of late 2008 were replete with bank failures and collapses, bail-outs and bonus scandals. A certain banking fatigue set in and it was with a sigh of relief that the big banks seemed to have survived and then passed the stress tests organized by the Treasury earlier this year.

Not so fast.

Those self-same banks are right back at it. Even a cursory look at recent bank activities suggests that their behavior is little changed. Yes leverage [the ration of total assets to capital] is way down from the ridiculous and unsustainable levels that brought about the implosion, but there is absolutely no evidence that they would not pump themselves back up once the economy gets under way.

The biggest obstacle to getting a sound banking system is moral hazard. This is the idea that someone – a bank in this case – can undertake an otherwise excessively risky course of action because they are aware, a priori, that they will be saved from the consequences of that action.

Banking is rife with moral hazard. In fact it is the poster child for the concept.

As long as regulators, the government, and ultimately the taxpayer are viewed as a credible back-stop to the reckless speculation, gambling, trading of the big banks they have no incentive to rein in the yahoos who inhabit their trading desks.

And the problem is that these folks are really clever yahoos.

They have figured out that they can undertake inordinate risks without compunction because they will never have to face the consequences. The individual traders have every reason to go beyond the limits of reason because their bonus structure pays them on short term profits not long term profits. So a gain of $1 million today produces a nice bonus which is not subject to reduction when that gain turns into a $100 million loss a year from now. The traders and bankers keep their bonuses whatever the future reversal of fortune may be.

This is why the crisis did not produce many bankruptcies amongst the banker elite: their cash was already stashed away when the bottom fell out of their scams trades.

You and I were not so fortunate.

Nor are the shareholders driven to avoid the same risks. Stock prices are intensely related to short term profits. So a shareholder can sell a holding once the stock has run up in price, no matter how illusory the profits are upon which that price is based.

Then, when the collapse comes, the shareholders simply turn to the taxpayer and expect to be bailed out – after all bank ‘A’ is simply too big to fail.

So moral hazard has the perverse effect of turning the yahoo, French cuff crowd on Wall Street, that epicenter of capitalist cheerleading, into a bunch of socialists.

They loot the banks for private gain and then leave the corpse for us to revive. More to the point: they have the gall to expect to be allowed to do this. They get all hissy when someone points out their utter incompetence and they counter by claiming we don’t understand banking – filled as it is with jargon and abstract modeling nowadays.

My position is that any industry that loses as much as banking did, and destroys as much wealth along with it, and then requires life support from the public, has little room for hubris.

Bankers are the ones, based upon their demonstrated performance, who don’t understand banking. Unless, that is, your definition of banking is a scheme to bilk the public of a fortune before retiring to the Hamptons/Connecticut/Park Avenue.

These people are the world’s richest socialists. Even the hey day of the Politburo failed to match this crowd for the looting and personal aggrandizement rife on Wall Street.

So, as we turn our attention to bank reform we need to engineer a way to remove these guys from our payroll. They cost too much. Next time they gamble it has to be with their own money. And if they need our cash for help some of them have to go bankrupt before we pay up.

Eliminating moral hazard is easier said than done however. Banks are central to the economy. That’s why they get away with the games they do.

So to attack them we need to target carefully. We may not be able to eliminate moral hazard but we can make it really painful for these dangerous people to rob us again.

We can make them put up more capital. Perhaps a part of the capital base has to be contributed by the trader/managers of the bank. Perhaps the top paid folks only get capital shares and not cash. Irredeemable shares for some period – say ten years. Force them to have skin in the game sufficient to make them think twice about risk. We need to send Goldman Sachs back to the days of real partnership, not this faux, quasi socialist, partnership that they revel in today. Partners should lose every cent – yes even the Hamptons cottage – they own before the taxpayer puts up a dime.

Then we can also penalize banks that get too big: force them to double the capital set aside for all assets over a certain size. Heck triple it. Do something to stop these behemoths swamping us.

Next: they should write ‘living wills’. One of the big problems today is the web of hiding places that banks syphon off their money into so they can avoid taxes. Their corporate structures are impenetrable. This was one of the main reasons no one wanted AIG to go belly up: no one had a clue where all the money was and what the consequences would be. A corporate living will would remedy this: it is a blueprint for bankruptcy. Once in place living wills vastly reduce the risks of a bank failure. As such they reduce the ability of a bank to force us to pay for its folly.

I would go further and break up the big banks, but that isn’t too popular. No one nowadays has the fortitude of Teddy Roosevelt we are all too beholden to corporate America. Oh well.

Lastly: the banks who get embroiled in the Byzantine labyrinths of derivative trades, cross-trades, swaps, swaps of swap, trades of cross swapped trades and so on, all of which has now been shown to add to rather than subtract from risk, should be penalized via extra capital requirements. make them pay for playing these games. The entire derivatives market needs a good dose of reality: hedging makes a ton of sense for a mid-west farmer trying to organize his/her cash flow. But the rest of the entire market is useless: it merely is a way to generate fees for lawyers, bankers, and accountants, none of whom, apparently, have a clue about the consequences of their actions.

Need I remind you of my bete noir: credit default swaps on US bonds? The insanity inherent in that transaction beggars belief.

So make them pay.

They should put up extra capital against derivatives. And the traders should have their pay linked directly to the successful unwinding of the deals. If the deal goes bad, the trader goes bankrupt. Simple. Clean. Effective.

The best way to contain the evils of moral hazard is to make it personal.

And until we drain the banking system of moral hazard we can be assured we are headed back into another bubble and thence into another recession.

That’s why bank reform is important.