Treasury Official Speaks Out About Excessive Risk Taking and Moral Hazard

This is a guest post by Isaac M. Gradman at The Subprime Shakeout.

Michael Barr

Michael Barr

At long last, someone in Washington is speaking out about the dangerous precedent set by the government bailouts of major banks. As discussed in this article on the financial regulations website FinReg21, Treasury secretary Michael Barr testified before the House Judiciary subcommittee that the government must enact meaningful reforms to combat the “classic moral hazard problem” that stems from the perception that some banks are too big to fail.

Moral hazard defines the concept that an actor who is insulated in some way from risk will often behave in a riskier or more aggressive manner as a result of that insulation. The classic example is that drivers wearing seat belts and bikers wearing helmets tend to drive and bike more aggressively than they would have if unprotected, thereby leading to more accidents than before. Applied to the banking industry, Barr’s reference to moral hazard suggests that banks (and their creditors) that are perceived as “too big to fail” (i.e., the government will bail them out rather than letting them fail) will be incentivized to engage in greater risk-taking behavior than they would have if there had been a credible fear of failure.

Examples abound of this type of perverse incentive system within the financial services industry. One need look no further than the examples of Freddie Mac and Fannie Mae, which continued to receive support for their risky mortgage-backed securities purchases from investors because it was thought that the government would guarantee the debts of these GSEs. Similarly, the performance of executives of financial institutions is scrutinized on a quarter-by-quarter basis, meaning that these executives must show constant short-term profits to retain their jobs. They are then rewarded for these short-term profits with huge bonuses. On the flipside, unless criminal or grossly negligent behavior can be shown, these executives are rarely liable for any losses the firm experiences because of their choices. Though they may lose their jobs, these executives generally retain the bonuses they’ve received, thus incentivizing highly risky behavior during their tenures.

The incentives for both executives and the institutions they direct must be restructured so that long-term profit and steady, sustainable growth is most richly rewarded, while wild volatility is discouraged. This must begin with erasing the notion that any institution is “too big to fail.” Beyond the moral hazard problem, the fact than any institution would be so critical to our economy that its failure would wreak havoc must be considered extremely dangerous. If the American economy is viewed as a portfolio of investments, then there must be sufficient diversification between industries and within industries such that the failure of one may be balanced against the others. Having our economy hinge on the success or failure of any one institution, let alone a highly leveraged institution such as a bank, is as bad a strategy as it would be for an individual to have his entire retirement account consist of holdings of Google stock.

So, what does this mean? If a bank or any other institution takes risks that don’t pan out, it must suffer the consequences. If it cannot overcome the losses from its risk-taking behavior, it must be allowed to fail. As Barr points out, this “failure” must consist of an orderly unwinding of assets, rather than a sudden collapse, as was the case with Lehman. But, it also cannot be a bailout. Investors must lose a portion of their investment, so that they will be incentivized to direct their resources towards companies that engage in prudent behavior. Upstart institutions must be allowed to sprout in the void left by the failed institution, replacing some of the lost jobs and services and encouraging a return to a survival-of-the-fittest brand of capitalism.

Consistently applying this approach over time will naturally lead to more conservative investments and decisions, but also to more realistic valuations. We all saw how unchecked risk-taking in mortgage lending led to highly inflated home prices that could not be supported and eventually came crashing down.

Now, I recognize that many will point to the failure of Lehman Brothers as an indication of why we should not let big financial institutions fail. Obviously, the failure of Lehman touched off a wave of financial disasters that pushed our economy into recession. The resolution authority proposed by Barr may be part of the answer to this objection. Yet, who can say that this recession was not an inevitable result of too many dollars chasing too little actual value? Would this recession really have been avoided if Lehman were propped up by the taxpayers instead of forced into bankruptcy? I think that to blame the financial crash on the fall of Lehman is to mistake a symptom for a cause. It is like saying that the Great Depression was caused by the stock market crash of 1927.

Further, reforming the bankruptcy process for major financial institutions is only part of the solution. A complete solution must involve a drastic reformation of executive compensation structures to reflect an emphasis on long-term value. Instead of basing executive bonuses on quarterly or yearly performance, have executive bonuses “vest” over a five-year period, provided that the executive remains employed with the company, and that the company (or the executive’s department or division) has shown a net profit over that period. This would incentivize both long-term planning and company loyalty.

While I applaud Barr for admitting the dangers of government bailouts, his proposed solution does not go far enough. Further, as I’ve discussed in the past, allowing the Fed to retain the authority to decide when this resolution authority is applied and withheld gives too much power to a private corporation with a vested interest in preserving certain large banks. There must be a better way.
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