Moral hazard’, a problem first noted as originating in insurance (as long ago as the middle ages), has been a well studied phenomenon in finance since the 1960s, yet, despite this, was the main cause of the credit crisis.
It arises when an individual or institution does not have to take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it alternatively would, leaving another party to hold some responsibility for the consequences of those actions.
An example, a person with insurance against car theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.
Moral hazard also arises in a principal-agent situation where one party, an agent, acts on behalf of a principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
In the mortgage market, securitisation introduced the agent-principal model to credit distribution in property finance, enabling a huge explosion of credit worldwide, but with a deep rooted moral hazard embedded in the edifice of credit that was built.
In deciding what to do about Ireland’s credit crisis, the question of moral hazard looms large again.
The history of modern Irish banking, which ended its most recent chapter in the events of the past two years, did, have a strong element of moral hazard in the story. It dates back to the 1980s, when Allied Irish Bank was bailed out by the Irish Government following the catastrophic losses it faced in Insurance Corporation of Ireland. The Irish Government picked up the tab, and the insurance levy imposed on insurance policies taken out by taxpayers (an unrelated party bearing the consequences of the doings of others) recouped the losses over time.
Thanks to the ICI episode, ‘too big to fail’ was a feature too of the history of Irish banking over the past three decades.
Now, the wheel has come full circle, except with more savage potential consequences for the taxpayer. It probably, on balance, would be fair to conclude that the extra savagery of the credit consequences now being faced by Irish taxpayers finds its roots in Ireland’s own ‘too big to fail’ crisis back in the 1980s.
It is now time to call a halt. The provision in the NAMA legislation that enables equity shareholders in the banks at the time of the crash (Autumn 2008) to emerge with anything more than a non zero sum should not be invoked at the expense of the taxpayer.
A moral hazard also exists in regard to the subordinated debt and deposit guarantees. This publication supported the decision to introduce it in October 2008, because it was necessary to protect the systemic integrity of the money system at the time of the bank guarantee. The blanket guarantee introduced then now has a little more than a year to run, and proposals should begin to be put in place to make an orderly withdrawal from that arrangement too, with a target for the reasonable medium term of scaling back the extent of the Irish guarantee to comparable international levels.
If moral hazard was cleared out of the equation regarding the banks entering the NAMA/Guarantee scheme, then the taxpayer-owned NAMA and the taxpayer-owned banks will not have an embedded conflict of interest in determining the valuation of assets. This could facilitate an orderly re-financing of the banking system, and the restoration of stability to the property market (which will be a required element in any economic stabilisation plan for the Irish economy).
At the end of the day, such a solution will require ‘nationalisation’. In normal circumstances it would be anathema for this publication to suggest such a course, but the system is broken, and must be put under repair, before a new privatisation of the banks concerned takes place.
When the time for re-privatisation of Irish banking comes, and it should at the earliest available opportunity, the new framework that should be established must have moral hazard stripped out of the equation for once and for all, and that applies to all aspects of the new framework. That will include the remuneration of the executives that will run the Irish banks of the future. One of the lessons of the present crisis is that incentivising management with equity options was a recipe for encouraging the imprudent risk taking that bedevilled the global and Irish banking systems.
Our July issue provided many good ideas on the way forward for financial regulation in Ireland. The Industry Panel of the Regulator in its just published report also reinforces many of these points, and positively, reinforces their earlier calls for an appropriate system of regulation for the IFSC.
The moral hazard agenda set out in the above paragraphs should centrally inform the future plan to reform the financial regulatory landscape in Ireland.
The Industry Panel also makes the point that people will be key, and that structures are just that – and no more. We would quibble with an emphasis in the report that staff should (or need?) to be well remunerated however. The staff in the Regulator will be public servants, and the time has come, as part of the drive to recruit more good people into the Regulator, to emphasise public interest, and public service in the job description. For too long public service in Ireland has been equated with high pay, and a need for public servants to be served at public expense. The daily mounting horror of the Finance Dublin debt clock (www.financedublin.com/debtclock) is ample evidence of the continued drain on the nation of politician, judiciary, and “public servant” pay and perks. The time has come for greed and monetary interest to take a back seat in both the private and public sectors.