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Analysis: Moral hazard and risk - I

By SAM VAKNIN, UPI Senior Business Correspondent

SKOPJE, Macedonia, May 30 (UPI) -- The reallocation and transfer of risk are booming industries. Governments, capital markets, banks and insurance companies have all entered the fray with ever-evolving financial instruments. Pundits praise the virtues of the commodification and trading of risk. It allows entrepreneurs to assume more of it, banks to get rid of it, and traders to hedge against it. Modern risk exchanges liberated Western economies from the tyranny of the uncertain -- they enthuse.

But this is precisely the peril of these new developments. They mass manufacture moral hazard. They remove the only immutable incentive to succeed -- market discipline and business failure. They undermine the very fundaments of capitalism: prices as signals, transmission channels, risk and reward, opportunity cost. Risk reallocation, risk transfer, and risk trading create an artificial universe in which synthetic contracts replace real ones and third party and moral hazards replace business risks.

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Moral hazard is the risk that the behavior of an economic player will change as a result of the alleviation of real or perceived potential costs. It has often been claimed that International Monetary Fund bailouts, in the wake of financial crises -- in Mexico, Brazil, Asia and Turkey, to mention but a few -- created moral hazard.

Governments are willing to act imprudently, safe in the knowledge that the IMF is a lender of last resort, which is often steered by geopolitical considerations, rather than merely economic ones. Creditors are more willing to lend and at lower rates, reassured by the IMF's default-staving safety net. Conversely, the IMF's refusals to assist Russia in 1998 and Argentina this year should reduce moral hazard.

The IMF, of course, denies this. In a paper titled "IMF Financing and Moral Hazard," published June 2001, the authors -- Timothy Lane and Steven Phillips, two senior IMF economists -- state:

"... In order to make the case for abolishing or drastically overhauling the IMF, one must show ... that the moral hazard generated by the availability of IMF financing overshadows any potentially beneficial effects in mitigating crises ... Despite many assertions in policy discussions that moral hazard is a major cause of financial crises, there has been astonishingly little effort to provide empirical support for this belief."

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Yet, no one knows how to measure moral hazard. In an efficient market, interest rate spreads on bonds reflect all the information available to investors, not merely the existence of moral hazard. Market reaction is often delayed, partial, or distorted by subsequent developments.

Moreover, charges of "moral hazard" are frequently ill informed and haphazard. Even the venerable Wall Street Journal fell in this fashionable trap. It labeled the Long Term Capital Management 1998 salvage -- "$3.5 trillion worth of moral hazard." Yet, no public money was used to rescue the sinking hedge fund and investors lost most of their capital when the new lenders took over 90 percent of LTCM's equity.

In an inflationary turn of phrase, "moral hazard" is now taken to encompass anti-cyclical measures, such as interest rate cuts. The Fed -- and its Chairman Alan Greenspan -- stand accused of bailing out the bloated stock market by engaging in an uncontrolled spree of interest rates reductions.

In a September 2001 paper titled "Moral Hazard and the U.S. Stock Market", the authors -- Marcus Miller, Paul Weller and Lei Zhang, all respected academics -- accuse the Fed of creating a "Greenspan Put." In a scathing commentary, they write: "The risk premium in the U.S. stock market has fallen far below its historic level ... (It may have been) reduced by one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk ... This insurance -- referred to as the Greenspan Put -- (involves) exaggerated faith in the stabilizing power of Mr. Greenspan."

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Moral hazard infringes upon both transparency and accountability. It is never explicit or known in advance. It is always arbitrary, or subject to political and geopolitical considerations. Thus, it serves to increase uncertainty rather than decrease it. And by protecting private investors and creditors from the outcomes of their errors and misjudgments -- it undermines the concept of liability.

The recurrent rescues of Mexico -- following its systemic crises in 1976, 1982, 1988, and 1994 -- are textbook examples of moral hazard. The Cato Institute called them, in a 1995 Policy Analysis paper, "palliatives" which create "perverse incentives" with regards to what it considers to be misguided Mexican public policies, such as refusing to float the peso.

Still, it can be convincingly argued that the problem of moral hazard is most acute in the private sector. Sovereigns can always inflate their way out of domestic debt. Private foreign creditors implicitly assume multilateral bailouts and endless rescheduling when lending to TBTF or TITF ("too big or too important to fail") countries. The debt of many sovereign borrowers, therefore, is immune to terminal default.

Not so with private debtors. In remarks made by Gary Stern, president of the Federal Reserve Bank of Minneapolis, to the 35th Annual Conference on Bank Structure and Competition, in May 1999, he said:

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"I propose combining market signals of risk with the best aspects of current regulation to help mitigate the moral hazard problem that is most acute with our largest banks ... The actual regulatory and legal changes introduced over the period-although positive steps-are inadequate to address the safety net's perversion of the risk/return trade-off."

This observation is truer now than ever. Mass-consolidation in the banking sector, mergers with non-banking financial intermediaries (such as insurance companies), and the introduction of credit derivatives and other financial innovations -- make the issue of moral hazard all the more pressing.

Consider deposit insurance, provided by virtually every government in the world. It allows the banks to pay to depositors interest rates, which do not reflect the banks' inherent riskiness. As the costs of their liabilities decline to unrealistic levels, banks misprice their assets as well. They end up charging borrowers the wrong interest rates or, more common, financing risky projects.

Badly managed banks pay higher premiums to secure federal deposit insurance. But this disincentive is woefully inadequate and disproportionate to the enormous benefits reaped by virtue of having a safety net. Stern dismisses this approach: "The ability of regulators to contain moral hazard directly is limited. Moral hazard results when economic agents do not bear the marginal costs of their actions. Regulatory reforms can alter marginal costs but they accomplish this task through very crude and often exploitable tactics. There should be limited confidence that regulation and supervision will lead to bank closures before institutions become insolvent. In particular, reliance on lagging regulatory measures, restrictive regulatory and legal norms, and the ability of banks to quickly alter their risk profile have often resulted in costly failures."

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Stern concludes his remarks by repeating the age-old advice: caveat emptor. Let depositors and creditors suffer losses. This will enhance their propensity to discipline market players. They are also likely to become more selective and invest in assets, which conform to their risk aversion.

Both outcomes are highly dubious. Private sector creditors and depositors have little leverage over delinquent debtors or banks. When Russia -- and trigger happy Russian firms -- defaulted on their obligations in 1998, even the largest lenders, such as the European Bank for Reconstruction and Development, were unable to recover their credits and investments.

The defrauded depositors of BCCI are still chasing the assets of the defunct bank as well as litigating against the Bank of England for allegedly having failed to supervise it. Discipline imposed by depositors and creditors often result in a "run on the bank" -- or in bankruptcy. The presumed ability of stakeholders to discipline risky enterprises, hazardous financial institutions, and profligate sovereigns is fallacious.

Asset selection within a well-balanced and diversified portfolio is also a bit of a daydream. Information -- even in the most regulated and liquid markets -- is partial, distorted, manipulative, and lagging. Insiders collude to monopolize it and obtain a "first mover" advantage.

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Intricate nets of patronage exclude the vast majority of shareholders and co-opt ostensible checks and balances -- such as auditors, legislators, and regulators. Enough to mention Enron and its accountants, the formerly much vaunted Andersen.


(Comments to: [email protected])

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