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Wednesday, 2 February 2011

Moral Hazard, But Thanks For All The Fish

Vanishing Regulators

Regulators spend a lot of time worrying out loud about moral hazard, the problem that occurs when people don’t have to take risks commensurate with their potential rewards. This sort of ignores the point that if moral hazard didn’t exist most of the need for regulators would disappear overnight.

Still, there’s a sneaking suspicion that a lot of the problems investors face are less to do with moral hazard and more to do with the problems caused by behavioural biases that cause organizations to fail to manage information successfully. This so-called intellectual hazard, it’s suggested, lies behind some of the securities industries biggest boo-boos.

Burning Down the House

Moral hazard is usually best described by reference to the insurance industry. An insurance policy against your car being stolen or your house burning down may create an incentive for you to arrange to have your car purloined or your home firebombed. Hence life insurance policies don't pay out if you self-terminate. So the insurance policy itself constitutes an additional risk for the insurer.

During the great financial crisis of 2008 many UK savers found themselves temporarily embarrassed when the Icelandic banks collapsed. These savers had been seeking the extra interest offered by these institutions, generally encouraged by a range of best buy websites supposedly offering consumers the best information available. The theory was that these banks were protected by deposit insurance schemes up to the same level as UK based institutions.

Fishy Accounting

While nice in theory the practice was somewhat different. The Icelandic banks were offering higher rates in a desperate attempt to attract deposits because their balance sheets were weak after rather a lot of misguided expansion which largely involved buying lots of British retail chains that the British didn't use any more. When they imploded a lot of UK savers suddenly discovered that the 5.8 billion dollars worth of their money that had gone missing was now the responsibility of the generally easy going and friendly tax paying Icelandic population, all 200,000 or so of them. Remember that this is an economy based on "marine products", and that's a heck of a lot of fish.

Spotting a potential vote loser the British government bailed out individuals – but not institutions – and set about getting its money back from the Icelandic government. As previous attempts at gunboat diplomacy had failed in the 1970's during the Cod War, when the pride of the British navy was beaten up by a bunch of Icelandic trawlermen, the UK enlisted the European Union to do its bullying for it by threatening not to let Iceland join the EU. Of course, as it turned out this was akin to denying a recovering alcoholic entry to a binge drinking club in a distillery.

Meanwhile British savers, reassured that they weren't ever likely to pay for their greed and stupidity, went back to their worst buy websites and promptly moved their money en-masse to the "Celtic Tiger", aka Ireland, now a rather poorly pussy. Presumably this was on the grounds that one heavily indebted Northern European island nation is as good as any other as long as the government's going to bail you out.

Fundamentally Flawed

While moral hazard is clearly implicated in these events it’s less certain that it was a significant factor in the way business created the financial crisis that was the proximate cause of the implosion of Icelandic banks. While many institutions were indeed too big to fail it doesn’t really appear that most financial institution executives were taking extreme gambles in the expectation that they’d be bailed out: rather it looks like they didn’t understand the risks they were taking in the first place.

As Larry Summers explains this in Beware Moral Hazard Fundamentalists there’s a complex relationship between moral hazard, confidence and liquidity:
“Moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent, as misguided lending or borrowing causes their liabilities to exceed their assets. But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough”.
Intellectually Hazardous

Geoffrey Miller and Gerald Rosenfeld in Intellectual Hazard: How Conceptual Biases in Complex Organizations Contributed to the Crisis of 2008 argue that major but entirely elementary errors can occur in complex institutions when these fail to manage the information necessary to manage their risks properly:
“Intellectual hazard, as we define it, is the tendency of behavioral biases to interfere with accurate thought and analysis within complex organizations, thus interfering with the acquisition, analysis, communication and implementation of information both within an organization and between an organization and external parties”.
The similarities between moral and intellectual hazard lie in the way that they’re designed to ensure risk is moved to those best equipped to deal with it but may end up accidentally increasing that risk. So just as moral hazard can arise out of insurance policies that divorce the risk taker from the risk so intellectual hazard arises by dividing organizations into specialist areas designed to mitigate risk.

Behavioral Hazard

A number of different types of behavioral bias are implicated in these failures. The researchers point to three classes of problems as being major factors: Complexity Biases, Incentive Biases and Asymmetry Biases. Complexity biases occur where an individual fails to analyse all of the information available: we've described confirmation bias, for instance, where people only take into account information that confirms their opinions is an example. Another is authoritarian bias, where undue weight is given to supposedly expert sources.

Incentive biases are all about self-interest and avoiding the nasty feelings that come out of trying to match one’s expectations with contradictory information. As we also shown, loss aversion is a typical example, as people try to find ways to avoid accepting a loss. Asymmetry biases occur when people bring their expectations to the table and try to make reality align with it – status quo bias for instance, where the tendency is to stick with what you "know" rather than adjust your thinking to a new reality.

A Feast of Biases

Out of this smorgasbord of behavioral biases the authors construct a network of intermeshing and interacting components which together make up the complex reality of the modern financial system. They point to model builders and their operators, banking executives, central bankers, regulators, credit rating agencies and even the ultimate arbiters of risk management, the Basel Committee, and draw out a range of these biases which impacted upon their respective abilities to manage risk. The point being of course, that they all failed to one degree or another and that arbitrary allocation of blame in one particular area is to miss the point by a long country mile.

The question is, though, whether this motley collection of behavioural biases as applied to an even motlier collection of financial agents is sufficient to explain the repeated ability of markets to convince themselves that the past is another country and that all that matters is the present day. Even more pertinent, perhaps, is whether it provides a template to prevent such failures reoccurring.

Well, it’s perhaps a jaundiced view, but it seems unlikely. It’s not that the failures described aren’t genuine but that the problems that underpin them are likely to be both more fundamental and more pervasive than it first appears. Moral hazard occurs by separating the risk from the risk taker and by inadvertently incentivising the latter to, at best, take more risks and, at worst, to try and game the system. When everyone starts playing the game the market itself breaks down.

Inevitable Hazards

To the extent that complexity is an endemic part of modern financial systems it’s likely that intellectual hazard is also inevitable because it’s also essential that we allocate risk to those most capable of bearing it. If this means spreading risks between different components of the systems then moral hazard in its intellectual form will creep through the system via the inevitable accretion of behavioural biases. For an example of this read Mark Flannery's Iceland's Failed Banks: A Post-Mortem: banking is a business that's opaque at best, at worst it's a Ponzi Scheme where the smoking gun is a grumbling volcano.

As an answer this is profoundly unsatisfactory but is probably part of the human condition. A world in stasis where no one takes risks is a world going backwards; if the consequence of that is the occasional major crisis then that’s probably a price worth paying. In any case, it's doubtful if we have a choice: caveat emptor, investor.

Related Articles: Complexity in Financial Systems, Physics Risk Isn't Market Uncertainty, Gaming the System

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