Moral Hazard and Future Crises

In a column in yesterday's Washington Post, Simon Johnson and James Kwak argue rightly (and obviously) that the greatest lasting impact of the financial crisis that began with the Lehman collapse a year ago is the moral hazard greatly increased if not created by public bailouts. For Johnson and Kwak, there are three sources of moral hazard:

First, bank employees and managers had asymmetric compensation structures. In good years, they stood to make huge amounts of money; in bad years, even if the bank lost money, they would still make healthy sums. This gave employees the incentive to take excessive risks because they could shift their potential losses to shareholders.

Second, shareholders had the same payoff structure. Banks are highly leveraged institutions; every dollar contributed by shareholders is magnified by 10 to 30 dollars from creditors. This meant that in good years, shareholders benefited from profits that were juiced by leverage, but should things go wrong, they could shift their potential losses to creditors. As a result, paying bank executives in stock did not mitigate their behavior; in fact, the most senior executives at both Bear Stearns and Lehman had and lost enormous amounts of money tied up in their companies.

Third, creditors had only limited incentives to watch over major banks. Ordinarily, creditors should demand high interest rates on loans to highly leveraged institutions. However, the expectation that large banks would not be allowed to fail made creditors more willing to lend to them.

Not mentioned is the increased capacity of financial institutions to hide non-performing assets through accounting rule changes. There is little incentive to declare market values and/or take write-downs when the assurance of public rescue exists. Bonuses and dividends continued to be paid, tacitly backed by the public purse.

Nor is Canada immune from this. Recall that our banks were able to unload $65 billion of questionable loans on the federal government, encouraging them in the future to reap the profits of such loans while offloading losses on the public.