Moral Hazard Explained: Okamoto’s Fine Grain Account Of Market Failure

We’ve heard a lot about moral hazard recently.  The coarse account is that we should worry about bailing out risk-takers lest they come to rely on bailouts in their future risk calculations.   But moral hazard can have a finer grain presence in the ways that individual risk managers risk assessment.  My colleague Karl Okamoto has been doing some writing recently about this aspect of market failure.  His new piece, After the Bailout: Regulating Systemic Moral Hazard is a particularly intriguing contribution for those interested in figuring out the right way to attack the specific problems that may have triggered our current plight.  One of his primary proposals is that risk managers be required to have “skin in the game”: they’ll behave better if they have some of their own loot at stake.  Another is development of a best practices regime that provides some (limited) controls on risk manager behavior.  As a former money manager, Okamoto tends toward the scalpel rather than the buzz-saw.  And his analysis relies on real knowledge of fund manager behavior rather than the phantasmagoric accounts we sometimes hear about in the press.

The abstract:

How do we make our financial world safer? This Article offers a strategy for regulating financial markets to better prevent the kind of disaster we have seen in recent months. By developing a model of risk manager decision-making, this Article illustrates how even “good people” acting in utterly rational and expected ways brought us into economic turmoil.

The assertion of this Article is that the root cause of the current financial crisis is systemic moral hazard. Systemic moral hazard poses a unique challenge in crafting a regulatory response. The challenge lies in that the best response to systemic moral hazard is “preventive prediction.” It is inherently difficult to reward individuals for producing preventive prediction. Therefore markets fail to produce it at optimal levels, and thus prevent systemic moral hazard and the kind of crisis we are facing.

The difficulty in valuing preventive prediction is seen when we model how risk managers make decisions regarding the prevention of excessive risk. The model reveals that the balance is easily tipped in favor of risk-taking that leads to systemic failure and broad social harm. The model also reveals how regulation might work to reset the balance to one that is superior for society. We achieve this by imposing two requirements on all asset managers in the market: we require them to put their own money at risk in their trading decisions, and we require them to use “best practices” in managing risk. These prescriptions arise out of a regulatory strategy that accepts the need to balance the benefits of risk-taking in financial markets (and the consequent inevitability of some financial failure) with the desire to avoid excessive risk-taking and the costs of systemic collapse. It is a strategy that focuses on those instances where we cannot trust ourselves to be prudent.