Literally millions of words have already been written to talk about financial crisis of 2007-08 that has caused global economic recession. So one is unlikely to say something which is new on this issue now! One explanation is that savings from fast growing Asian economies and Middle Eastern savings from rising oil prices found their way into spending spree by the consumers in the developed west where, in particular, the US, these savings also fuelled housing boom. So when that unsustainable boom arising from consuming west and saving east burst we got the financial crisis. Therefore, why bother reading any more about it you may ask.
That’s perfectly valid question to ask. Here are some questions for you to check. What explains this crisis? why did highly paid and highly ‘qualified’ risk managers of some of the biggest banks in the world goof up? what is the meaning of moral hazard? and how that affects our daily life decisions? If you know the answers to these questions, please don’t read further. But if you are interested in exploring the answers to these questions with me, read on.
We begin by noting that social innovations have impact and many unintended consequences too on the society. The present financial crisis is an example of how the financial instruments that were invented to manage risks ended up creating financial risk for whole world. Let’s see how.
On the last day of 16th century, 31 December 1600, Queen Elizabeth I of England granted a charter to group of merchants from England forming a joint stock trading company called East India Company (EIC). The EIC lasted 258 years and did much more than just trading. The point is that joint stock company form of organising and managing trade got quickly replicated by Dutch and French too. Eventually, company as a form of organisation would transform the way business is done throughout the world. The limited liability public company is one of the most important social innovations of the last 4 centuries as it ensured that large scale business operations could be undertaken and that the smallest amounts of savings could used to finance those operations with the liability for the shareholder restricted to the nominal value of the equity share. Equity share in this way offers a maximum downside loss equal to the purchase price but the potential gains are unlimited if company performs well. But large number of shareholders meant that business of companies is managed by managers who may or may not be the shareholders. This results in potential conflict of interests between the shareholders (owners also called principals) and managers (agents). This agency problem can be very severe if the agents have far more knowledge about the business than the principals. And this is true in case of public limited companies. The knowledge and information advantage can create a moral hazard situation.
What is moral hazard? Moral hazard occurs when one of the two parties to a transaction behaves in a way that may potentially harm the interest of other party. This could happen when say a seller has more information about a product than a buyer has. For example, if as an insurance salesman I sell you an insurance policy which is of little real use in protecting your interests or I sell you a mortgage knowing that you may not be in position to honour the payments in time. Why will I do so? Well if my employment contract offers me incentives based on how many mortgages I sell I will do so. Moral hazard is very common in many day to day situations for example between professional advisors and their clients in medical, law or accounting and finance settings. Associated with moral hazard is the agency problem.
To deal with moral hazard and agency problems, most professions have their codes of conduct and so it is true for the managers of commercial companies, there are what is called corporate governance codes such as Combined Code in the UK and Sarbanes Oxley Act in the US which try to align the interests of principals and agents. However, the recent experience with the banking industry taking enormous levels of risks, has highlighted that the agency problem and moral hazard when they occur, can have devastating effects on not only the shareholders’ wealth but also on the wider community. Managers of banks giving housing loans to those borrowers who were not creditworthy enough were essentially taking business risks far beyond what prudential bankers would do. How does one explain this behaviour by not one odd small bank but by some of the biggest banks managed by highly qualified people? It can not be that they were unaware of the level of risks they were taking.
What would explain this behaviour is a combination of things. First is that there were incentives built into the remuneration packages of managers to maximise lending to earn higher returns by lending to high risk borrowers. But this alone was not sufficient condition. There are banking regulations and norms on capital requirements that would work as inherent check on the amount of lending that a bank could do. What helped the expansion of lending was the ability of banks to sell existing loans on their balance sheets to other investors and restart one more cycle of lending. This is a financial innovation called securitisation but it is not new and has been around for quite sometime. However, this process is not easy, before those bundles of loans can be sold to other investors, they have to be seen as worthy investments. For this, the prospective investors look at the credit ratings given by the agencies such as Standard and Poor and Moody’s. These ratings effectively are a judgement by these agencies about the soundness of those bundles of loans. In this case it turned out that many such assets with high ratings, called investment grades, later turned out to be much more risky than their ratings indicated. A further boost to the market for such mortgage based securities was provided by another financial innovation. Investors investing in securitised assets knew that there are always chances of some mortgage borrowers defaulting and therefore, the investments comprising such assets would be worthless in such situation. So companies like American International Group (AIG) would offer insurance protection against such assets becoming worth less. This is called Credit Default insurance. Thus the recipe for taking big risks by loan originating banks was complete and most banks participated in the housing finance boom in the US until it burst.
The cycle worked like this: Easy funding for banks from wholesale money markets, incentives for bank managers to lend more without due regard to creditworthiness of the borrowers, transfer the risky loans from balance sheet by selling them as bundles of loans (called asset backed assets or securitised assets) to other investors, those investors bought those because credit rating agencies gave them 'investment worthy grades' based in part on the fact that many of these loans were protected against the risk of defaults assured by insurance companies such as AIG, Freddie Mac and Fannie Mae. The cycle went on till 2006-07 when the borrowers of home loans started defaulting.
Everyone now knows the amount of risk that these banks took and its consequences are still unfolding. However, one big consequence of this has been a breakdown of trust between borrowers and lenders. Growth of finance and banking, just like the rest of the economy depends critically on the trust between the parties. If you reflect on the process we described earlier about expansion of lending it shows that managers of banks were entrusted by their principals, shareholders to manage the banks prudently, but they put their legally allowed remuneration interests ahead of overall risk they were creating. This brings into question the effectiveness of the remuneration committees in approving such compensation packages. Credit rating agencies failed in understanding the complexity and risks of the securitised products they were rating. Insurance companies offering insurance for products that were inherently very risky also failed their principals. The net result is crisis of confidence which has lingered on as lost trust among all stakeholders. This trust was built over decades but was destroyed in few months.
What is the way forward? For a start, individual incentives and behaviour cannot be ignored in analysing the current crisis. Hence remuneration policies and accountability will need to be factored into any new policy measures that the governments may consider. There is a simple but most powerful principle in economics and it is the relation between risk and reward. The remuneration policies in the banking industry simply violated this principle. While rewards were given in the short term, risks borne were of long term nature. The accountability in future must be individualised. Private gains and private losses both should be captured in the managerial compensation deals. The rebuilding of trust is bound to be a slow process and it can not be simply achieved by more and international regulation. The present crisis has shown there were regulatory failures and they need to be understood as well. More regulation, whether of national or supra-national character, will suffer from limitations of regulatory capabilities and competence. Confidence in markets where prudent management is rewarded will be slow to build, but that would seem more appropriate response.
That’s perfectly valid question to ask. Here are some questions for you to check. What explains this crisis? why did highly paid and highly ‘qualified’ risk managers of some of the biggest banks in the world goof up? what is the meaning of moral hazard? and how that affects our daily life decisions? If you know the answers to these questions, please don’t read further. But if you are interested in exploring the answers to these questions with me, read on.
We begin by noting that social innovations have impact and many unintended consequences too on the society. The present financial crisis is an example of how the financial instruments that were invented to manage risks ended up creating financial risk for whole world. Let’s see how.
On the last day of 16th century, 31 December 1600, Queen Elizabeth I of England granted a charter to group of merchants from England forming a joint stock trading company called East India Company (EIC). The EIC lasted 258 years and did much more than just trading. The point is that joint stock company form of organising and managing trade got quickly replicated by Dutch and French too. Eventually, company as a form of organisation would transform the way business is done throughout the world. The limited liability public company is one of the most important social innovations of the last 4 centuries as it ensured that large scale business operations could be undertaken and that the smallest amounts of savings could used to finance those operations with the liability for the shareholder restricted to the nominal value of the equity share. Equity share in this way offers a maximum downside loss equal to the purchase price but the potential gains are unlimited if company performs well. But large number of shareholders meant that business of companies is managed by managers who may or may not be the shareholders. This results in potential conflict of interests between the shareholders (owners also called principals) and managers (agents). This agency problem can be very severe if the agents have far more knowledge about the business than the principals. And this is true in case of public limited companies. The knowledge and information advantage can create a moral hazard situation.
What is moral hazard? Moral hazard occurs when one of the two parties to a transaction behaves in a way that may potentially harm the interest of other party. This could happen when say a seller has more information about a product than a buyer has. For example, if as an insurance salesman I sell you an insurance policy which is of little real use in protecting your interests or I sell you a mortgage knowing that you may not be in position to honour the payments in time. Why will I do so? Well if my employment contract offers me incentives based on how many mortgages I sell I will do so. Moral hazard is very common in many day to day situations for example between professional advisors and their clients in medical, law or accounting and finance settings. Associated with moral hazard is the agency problem.
To deal with moral hazard and agency problems, most professions have their codes of conduct and so it is true for the managers of commercial companies, there are what is called corporate governance codes such as Combined Code in the UK and Sarbanes Oxley Act in the US which try to align the interests of principals and agents. However, the recent experience with the banking industry taking enormous levels of risks, has highlighted that the agency problem and moral hazard when they occur, can have devastating effects on not only the shareholders’ wealth but also on the wider community. Managers of banks giving housing loans to those borrowers who were not creditworthy enough were essentially taking business risks far beyond what prudential bankers would do. How does one explain this behaviour by not one odd small bank but by some of the biggest banks managed by highly qualified people? It can not be that they were unaware of the level of risks they were taking.
What would explain this behaviour is a combination of things. First is that there were incentives built into the remuneration packages of managers to maximise lending to earn higher returns by lending to high risk borrowers. But this alone was not sufficient condition. There are banking regulations and norms on capital requirements that would work as inherent check on the amount of lending that a bank could do. What helped the expansion of lending was the ability of banks to sell existing loans on their balance sheets to other investors and restart one more cycle of lending. This is a financial innovation called securitisation but it is not new and has been around for quite sometime. However, this process is not easy, before those bundles of loans can be sold to other investors, they have to be seen as worthy investments. For this, the prospective investors look at the credit ratings given by the agencies such as Standard and Poor and Moody’s. These ratings effectively are a judgement by these agencies about the soundness of those bundles of loans. In this case it turned out that many such assets with high ratings, called investment grades, later turned out to be much more risky than their ratings indicated. A further boost to the market for such mortgage based securities was provided by another financial innovation. Investors investing in securitised assets knew that there are always chances of some mortgage borrowers defaulting and therefore, the investments comprising such assets would be worthless in such situation. So companies like American International Group (AIG) would offer insurance protection against such assets becoming worth less. This is called Credit Default insurance. Thus the recipe for taking big risks by loan originating banks was complete and most banks participated in the housing finance boom in the US until it burst.
The cycle worked like this: Easy funding for banks from wholesale money markets, incentives for bank managers to lend more without due regard to creditworthiness of the borrowers, transfer the risky loans from balance sheet by selling them as bundles of loans (called asset backed assets or securitised assets) to other investors, those investors bought those because credit rating agencies gave them 'investment worthy grades' based in part on the fact that many of these loans were protected against the risk of defaults assured by insurance companies such as AIG, Freddie Mac and Fannie Mae. The cycle went on till 2006-07 when the borrowers of home loans started defaulting.
Everyone now knows the amount of risk that these banks took and its consequences are still unfolding. However, one big consequence of this has been a breakdown of trust between borrowers and lenders. Growth of finance and banking, just like the rest of the economy depends critically on the trust between the parties. If you reflect on the process we described earlier about expansion of lending it shows that managers of banks were entrusted by their principals, shareholders to manage the banks prudently, but they put their legally allowed remuneration interests ahead of overall risk they were creating. This brings into question the effectiveness of the remuneration committees in approving such compensation packages. Credit rating agencies failed in understanding the complexity and risks of the securitised products they were rating. Insurance companies offering insurance for products that were inherently very risky also failed their principals. The net result is crisis of confidence which has lingered on as lost trust among all stakeholders. This trust was built over decades but was destroyed in few months.
What is the way forward? For a start, individual incentives and behaviour cannot be ignored in analysing the current crisis. Hence remuneration policies and accountability will need to be factored into any new policy measures that the governments may consider. There is a simple but most powerful principle in economics and it is the relation between risk and reward. The remuneration policies in the banking industry simply violated this principle. While rewards were given in the short term, risks borne were of long term nature. The accountability in future must be individualised. Private gains and private losses both should be captured in the managerial compensation deals. The rebuilding of trust is bound to be a slow process and it can not be simply achieved by more and international regulation. The present crisis has shown there were regulatory failures and they need to be understood as well. More regulation, whether of national or supra-national character, will suffer from limitations of regulatory capabilities and competence. Confidence in markets where prudent management is rewarded will be slow to build, but that would seem more appropriate response.
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Rightly said. This is actully not a Credit or Financial crisis but this is a crisis of Trust and Confidence and that is the reason even after billions of dollar being infused by various regulators, the situation is worsening by each passing day. As Dr. Kodwani put it - the course of gaining trust among relevant parties will take its own time. Wonderful article.
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