Moral Hazard

I think that the concept of “too big to fail” still exists today, as the financial services industry is still an oligopoly with few banks controlling the fate of the economy.  If, for example, a company like Citigroup, J.P. Morgan, or Bank of America were to go under at some point, the economy would fall apart.  Though it has tried to address the concern that banks could dismantle the financial system by regulating proprietary trading, capital requirements and others, the government has not addressed the problem of “moral hazard,” where investment banks take bigger risks because they are dealing with other people’s money and not their own.  The way to reform the banking system is to shift the risk to those that make the decisions to take the risk in the first place.  By requiring bank CEOs and other high-level executives to have some “skin in the game,” through having their compensation or personal assets at risk if a bank fails, it eliminates the incentive to take unnecessary risk in pursuit of higher returns (and higher bonuses). In practice, there will always be banks that are “too big to fail,” since these few banks have achieved economies of scale to support the United States (and even global) economy.  The trick is figuring out the way to keep these banks from ever failing.


13 comments on “Moral Hazard

  1. Your idea to shift the risk of failing to the CEOs and executives is a good one. I would agree that if CEOs and executives had to risk their compensation and personal assets while making a decision, they may be more careful and less reckless. Executive compensation is an issue since these executives are taking more risks to obtain higher profits, in hopes of receiving a greater return.

    • Severance packages is also a major issue with CEOs of big banks and big businesses in general. Home Depot had a CEO in the early 2000’s who failed miserably and was given around 200 million to leave his position. By altering these packages by performance as well you may create a safer and more risk adverse CEO.

      • I agree Tom, with these enormous severance packages there is not enough motivation for the CEOs to perform and adhere to ethical guidelines

  2. When banks fail, there are huge consequences, so I understand your point that, “the trick is figuring out the way to keep these banks from ever failing.” With that said, I think that all firms should be allowed to fail. Thats a key characteristic of a capitalist economy. In my opinion, what needs to change is the disastrous effects that the failure of an investment bank has on the entire economy. I think a solution would be to limit the size of banks to prevent them from becoming too big.

    • I really like your point that the banks should be allowed to fail. I agree that this is a central characteristic of a capitalist economy. The bail outs from 2008 have created a sense of security for these huge corporations and that is a real problem for our futures. By not bailing out companies and letting them fail it will hopefully teach businessmen to be more responsible. With that said I think Jason’s idea about interconnecting high level executives pay to the performance and health of the company is a smart idea, but one that would be very difficult to implement

      • Is there any way that a top executive’s assets could be at risk when a firm isn’t performing well? I doubt it because the firm is its own entity, responsible for its own debt. Plus, if compensation (positive or negative) is tied to performance, the firm runs into the same issue of high incentive to inflate the short term stock price…

      • The majority of high level executive’s compensations are through stock options while there base salary is small relatively speaking. So there is motivation for them to perform but necessarily to perform ethically.

    • I agree with you that banks should be allowed to fail, as we should not give a safety net to poorly managed firms. The problem with this is liquidity and the connection between the big banks and the world economy. The banking industry has consolidated (and is still consolidating) over the years, so that larger banks now hold the fate of the world economy on their balance sheets. Big banks can provide huge amounts of liquidity and limiting the size of them may hinder economic growth, as the market will be less liquid. It’s a tricky situation because in our capitalist theory, we want the poorly managed banks to fail without government involvement, but in practice, we cannot allow them to fail without crashing the global economy.

  3. I agree that in order for corporations to address the issue of moral hazard CEOs and execs should be held liable for taking on risk, but this a very complicated matter. Under a partnership structure rather than a corporation, CEOs and execs would actually be held liable for taking on risk. For example, if someone sues the firm, the partners of the firm are personally held liable and could lose their own personal assets. In order for this to happen, these corporations would need to completely change the structure of their firm.

    • It’s a tough situation. You are right that CEOs cannot legally have their personal assets held at risk in corporations and that banks would have to essentially become partnerships for their assets to be tied to the firm. My point was purely theoretical, but I believe that the underlying concept is true. There needs to be a way for executives to be punished (or rewarded significantly less) by poor company performance, creating a disincentive to take on excessive risk.

      • What tangles me up is that while this is appealing, punishing poor performance also sounds like maybe the beginning of the very shareholder ideology that Stout rails against.

        In other words, if CEOs are TOO TIED to narrow performance metrics, they will engage in short-term behavior.

        For example, over-leveraging their banks while they pressure mortgage originators to produce more and more loans; undermining their own risk-assessment procedures; insisting on regulations (or de-regulations) that benefit short-term choices.

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