Saturday, February 12, 2011

Moral Hazard

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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