Among a group of students who went through
architecture school together, one decided, after graduation, to pursue a career
on Wall Street, which he saw as a more certain path to financial security. Fifteen
years later, he got into financial trouble and asked his former classmates for
a loan, even though they all made substantially less income than he had. Some
in the class wanted to give him the loan while others thought that he should
live by the consequences of his choices.
Moral hazard describes any
situation in which a person or group remain insulated from the consequences of
their actions and so engage in unreasonable risky behavior, knowing that they
cannot lose. Frequently, those who take such risks have done two things to protect
themselves: they often have more information than others, which gives them an
advantage when things start to go wrong, and they often have set up the system
so that they will come out ahead regardless of what happens. While those
outside the system face the material hazard of actual losses, those on the
inside face the moral hazard of acting irresponsibly with little or no penalty.
The hedge-fund-fueled
crash on Wall Street in 2008 offered a painful example of the suffering
moral hazard can cause. Hedge funds, as their name implies, allow banks to
hedge their bets so that they come out ahead whether or not their investments
reap a profit or not, wagering for and against something at the same time. When
they use other people’s money and when inside information allows those making
such bets to insulate themselves from any losses, the level of moral hazard
rises accordingly. It would not matter if moral hazard only resulted in the
loss of an investor’s ethical moorings. But, as we saw after 2008, it often harms
a great many people, in that case, literally billions of people around the world.
The moral hazard of a few can become a real hazard to us all.
It can even become
hazardous to those who engage in it, as happened with this former architecture
student turned investment banker. Architects have a duty as licensed
professionals to protect the health, safety, and welfare of others, and as a
result, the built environment has all sorts of protective, durable, or
redundant features to ensure that buildings won’t collapse, systems won’t fail,
and inhabitants won’t get injured. Insulating other people – and themselves –
from such hazards remains a central part of what architects do. It may not seem
like such a leap, in that sense, to move from the physical protections of
architecture to the financial protections of investment banking. Both
architects and bankers have insider knowledge of how systems work that the
general public often does not, and both have designed products to not only
benefit their clients or customers, but also to protect the professionals
themselves against undue risk or liability.
The difference lies in the
risks they impose on others. Architects face little or no moral hazard in the
sense that they remain very exposed to litigation and to the loss of their
licenses should a state find them incompetent to practice. While they may take
aesthetic risks, most architects have an aversion to risk when it comes to others
health, safety and welfare – as they should. We have seen the opposite on Wall
Street. The reckless risk-taking with others money and the insulation from the
consequences of it via the taxpayer bailouts of the banks and insurance
companies involved in the 2008 debacle, show how morally hazardous investment
banking has become.
The solution to moral
hazard lies in ensuring that those who engage in unreasonable risk know – and
have to pay – the consequences of such behavior. On the policy level that means
that the government should not bail out financial institutions in the future that
continue to engage in the kind of actions that led to the 2008 economic collapse.
And in the case of this investment banker, it also means that his former classmates
should not bail him out, however much they might all be friends. Live by the
sword, die by the sword.
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