Moral hazard, time inconsistency, and banking in the long run

This post was written by Kevin O’Rourke

Will Hutton has an op-ed piece today in the Observer which includes some striking historical charts. These are extracted by a very interesting article by Andy Haldane, Executive Director, Financial Stability at the Bank of England. Haldane’s article is well worth a read, as a simple conceptualization of the long run problems facing financial regulators.

Money quote:

Haldane describes “the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, [these pose] a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.”

22 Responses to “Moral hazard, time inconsistency, and banking in the long run”

  1. Brian O' Hanlon Says:

    Thanks Kevin, Hutton’s articles over the summer which you linked here also were very, very useful. I liked paragraphs by Haldane such as this one:

    “Chart 8 plots a cross-section of global banks’ trading assets as a fraction of their total assets against their leverage. It suggests that efforts to expand balance sheets through higher leverage were focussed on trading assets. In the first part of this decade, rising asset prices delivered mark-to-market gains on banks’ expanding trading assets. This boosted their profitability and returns on equity. As long as asset prices rose, this created an Alice in Wonderland world in which everybody had won and all had prizes.”

    The real trouble here in Ireland is that we think we can get away with the activities described in the above paragraph and no one else in the entire world will be able to analyse what Ireland is doing. But the truth is, we are very transparent and probably the same tricks as we assume we invent on our own small island, have been done elsewhere and by much more skilled organisations than we have got. (Possibly with the same or similar crash)

    But today, I began to think about something Ronan Lyons said during the summer. That an export boom in the Irish economy might be all very well. However, it would merely bring us back onto parity with our trading partners. The only solution to the Irish economic problem really is a focus on domestic trade on the island.

    Maybe it is something to do with the fact I listened to Robert Shiller on YouTube all this week for the laugh, where he talks about booms and psychology. Part of the obstacle to domestic trade happening on our own tiny island is the psychological part. What we tend to forget here in Ireland, is that a major part of the population, in their middle years hold a lot of the wealth.

    They have had challenging experiences in the past in the 1980s recession. Speaking to some people over the weekend, I have noticed these people who command a certain wealth have started to go into 1980s shut down mode. For instance, one person I know wouldn’t even spend a couple of hundred Euro to solve a rodent infestation problem, due to the rise water levels in the storm systems, the rodent population has had to climb onto drier ground. Namely into peoples’ homes.

    There is a form of domestic ’service’ as an example. Much of the contents of the Pest Control charge would stay on the island and re-circulate in the system. But people in Ireland who have experience of the 1980s, believe 2009 is the start of a repeat episode. All of the old survival psychology that worked back then, when people were much younger, has been re-introduced. This presents problems for the Ronan Lyons type solution of an increase or stimulus of domestic based activities.

    We need to seriously look at this problem. The only reason I said I would rattle on for so many paragraphs on this vein - is the chaotic nature of economics. What started as a behaviour within the banking system, to do with leverage and marked-to-market traded assets - has no manifested elsewhere as a problem in psychology of our domestic population, who experience a deep recession twenty or thirty years hence.

  2. Brian O' Hanlon Says:

    The summary is, the point I am trying to make - Fianna Fail government have focussed debate in the media etc on this notion of Ireland being a small open economy. The point is, too many national school teachers, come politicians are getting too impressed by this rapid introduction to shiny new vocabularly and expressions like, small open economy.

    The problem we are experiencing directly here on this island is a basic one. A tightening of the purse strings by the ordinary joe soap, the likes of which no small economy, open, closed or what ever else, is likely to cope with.

    Like I said, the major portion of wealth on the island is held in coffers which belong to middle ages folk who have seen their kids squander it, and have deep and lasting psychological impressions from 30 years hence.

  3. Brian O' Hanlon Says:

    Expanded blogged version of the above for all your interest:

    http://designcomment.blogspot.com/2009/12/rats-on-sinking-ship.html

  4. kevin denny Says:

    An obvious question is whether Haldane’s analysis is relevant for Ireland. The “too big to fail” problem seems fairly applicable here too. But the ECB could (& should) more credibly say “Next time lads, you’re on your own”. That might help.

  5. E65Bn plus economic costs & NO extra lending! Says:

    @Kevin O’Rourke
    Just to take the examples of BOI and AIB:
    Both had operations in Britain so both must have been very aware of the property bubble/crash there in the early nineties.

    Additionally, I read the other day that BOI had lots of trouble with their US First New Hampshire subsidiary in the late eighties. The source of these difficulties? A property bubble/crash in New Hampshire. Pat Neary worked on this while in the Central Bank. BOI remained shareholders in a merged operation until 1998.

    AIB of course had the ICI scandal - when Garret Fitzgerald and Alan Dukes led a government that bailed them out. The bank has had a colourful past right up to it’s second disaster. The response of the current FF led government has been to bail them out. The response of Garret Fitzgerald and Alan Dukes: to enthusiastically support this second bail-out. If politicians keep on reacting in the same way what hope is there for bankers? Let’s hope Dukes succeeds in his new role on the board of Anglo. Otherwise he is going to be dubbed Alan Dukes of Moral Hazard.

  6. Brian O' Hanlon Says:

    I listend to Jim Womack (expert on Lean manufacturing systems) talk about China on podcast the other day. Womack relates how the Chinese factory of old, was the school, the hospital and the home of the Chinese workforce. He described it as a ‘control mechanism’. My point above really, is that the financial turmoil we are now experiencing, it doing at very good job as acting as a kind of ‘control mechanism’ over many folk in Ireland, who might otherwise go on spending their wealth on services, products etc that we might be able to exchange and trade between one another, in a sustainable way on our small island.

    In other words, unless Ireland develops its own system of internal trade, however modest it might be, we are creating a whole deal of trouble for ourselves. The funny thing is, the market system, which we don’t control in any way is what brought us here. Brought us all here faster than we would wish.

  7. Mick Costigan Says:

    @Kevin

    Worth noting that Simon Johnson drew strong attention to Haldane’s paper last week in the context of the Bernanke confirmation process.

    “The Haldane-Alessandri “doom loop” is fast becoming the new baseline view, i.e., if you want to explain what happened or – more interestingly – what can happen going forward, you need to position your arguments relative to the structure and data in their paper.”

    http://baselinescenario.com/2009/11/17/banking-in-a-state/

    I’ve been very impressed with everything Haldane has written over the course of the last year.

    @Brian O’Hanlon

    Very interesting. From the review in the Economist, it appears that Fintan O’Toole’s new book covers some similar ground. For unorthodox thoughts on growth, development and exports, try some Jane Jacobs on how economies grow. [Endogenously through non-centralized market-based import substitution and around cities is the brief answer]. I feel there are some interesting threads to connect here. See links and brief descriptions below:

    How Do We Grow? Jane Jacobs on Diversification and Specialization.
    “This recent paper from Challenge (May-June 2005) gives an expanded treatment of Jane Jacobs’ economic thought focusing on her theory of development and growth (or the lack thereof). In particular, it explains her remarkably insightful and unorthodox treatment of the issues of specialization and comparative advantage.”
    http://www.ellerman.org/Davids-Stuff/Dev-Theory/Challenge-final-scan.pdf

    The Economy of Regions
    by Jane Jacobs
    Third Annual E. F. Schumacher Lectures
    October 1983
    http://www.smallisbeautiful.org/publications/jacobs_83.html

  8. Cearbhall O Dalaigh Says:

    TIME INCONSISTENCY
    Wikipedia explains ‘time inconsistency;’
    “In economics, dynamic inconsistency, or time inconsistency, describes a situation where a decision-makers preferences change over time, such that what is preferred at one point in time is inconsistent with what is preferred at another point in time. It is often easiest to think about preferences over time in this context by thinking of decision-makers as being made up of many different “selves”, with each self representing the decision-maker at a different point in time. So, for example, there is my today self, my tomorrow self, my next Tuesday self, my year from now self, etc. The inconsistency will occur when somehow the preferences of some of the selves are not aligned with each other.”

    To me this seems like an argument as to why in certain circumstance I can justify reneging on ‘my word is my bond,’ or something along the lines of Cardinal Connell’s “mental reservation” concept.

    Here is an interesting paper: ‘Too many to fail–An analysis of time-inconsistency in bank closure policies.’
    http://ideas.repec.org/a/eee/jfinin/v16y2007i1p1-31.html

    By Viral V. Acharya, Professor of Finance, Stern School of Business, New York University (a colleague of Nouriel Roubini’s)http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

    Tanju Yorulmazer, Senior economist at the New York Federal Reserve
    http://www.newyorkfed.org/research/economists/yorulmazer/index.html

    MORAL HAZARD
    Wikipedia explains ‘moral hazard;’:
    “Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk.”

    In 2001, the Nobel Prize in Economics was awarded to Joe Stiglitz, George Akerlof and Michael Spence “for their analyses of markets with asymmetric information.”
    Information asymmetry models assume that at least one party to a transaction has what we normally describe as ‘inside information.’

    This is a very tricky area for bankers, especially from the ‘fiduciary duty’ viewpoint.
    Fiduciary duty is the highest standard of care in law.
    Here is a very general layman’s interpretation of the term:

    A person acting in a fiduciary capacity is required to make truthful and complete disclosures to those placing trust in them, and they are forbidden to obtain an unreasonable advantage at the latter’s expense. The best interest of the beneficiary must be primary
    A fiduciary is held to a standard of conduct and trust far greater than the comparable ‘duty of care’ in common law.
    A fiduciary must avoid ‘self-dealing’ or ‘conflicts of interests’ in which the potential benefit to the fiduciary is in conflict with what is best for the person who trusts them.

    A fiduciary relationship extends to every possible case in which one side places confidence in the other and such confidence is accepted; this causes dependence by one individual and influence by the other.
    The courts will stringently examine any transaction by which a dominant individual obtains any advantage or profit at the expense of the party under their influence. Such transaction, in which ‘undue influence of the fiduciary’ can be established, is void.

    Conduct by a fiduciary may be deemed constructive fraud when it is based on acts, omissions or concealments considered fraudulent and that gives one an advantage against the other because such conduct, though not actually fraudulent, dishonest or deceitful, demands redress for reasons of public policy.

    Breach of fiduciary duty may also occur in insider trading, when an insider or a related party makes trades based on material, non-public information obtained during the performance of the insider’s duties at the company. Where a principal can establish both a fiduciary duty and a breach of that duty through violation of the above rules, the benefit gained by the fiduciary should be returned to the principal because it would be unconscionable to allow the fiduciary to retain the benefit by employing his or her strict common law legal rights. This will be the case, unless the fiduciary can show there was full disclosure of the conflict of interest or profit and that the principal fully accepted and freely consented to the fiduciary’s course of action.

    Bank executives have a fiduciary duty to their company.
    This clearly illustrates why Irish bankers have strenuously fought to have their boards of directors retained, as it would appear that responsibility for enforcement lies with the bank board.
    One would assume that our Finance Minister Mr. Lenihan, a trained lawyer, is aware of this fact

    A fiduciary must act in the best interest of the company and act as trustee in regard of the assets of the company, be honest, divulge all conflicts of interest, and exercise skill. For example, a banker cannot lend money to somebody who is known to be unable to repay it, or would have been shown to be unable to pay it had the bank carried out even the most basic inquiries. If a bank did so they could be liable to having engaged in:

    fraud & deceit
    negligent misrepresentation
    civil conspiracy to commit fraud
    breach of fiduciary duty
    aiding and abetting breach of fiduciary duty
    gross negligence
    negligence
    civil conspiracy
    promissory estoppel (this prevents a party from acting in a certain way because the first party promised not to, and the second party relied on that promise and acted upon it).

  9. Cearbhall O Dalaigh Says:

    A free copy of ‘Too Many to Fail - An Analysis of Time-Inconsistency in Bank Closure Policies’ can be acquired here;

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=626242

  10. Graham Stull Says:

    Just read this paper. Excellent -worth reading, even for non-economists. Thanks for the link.

    - Graham

  11. Kevin O'Rourke Says:

    @Mick: thanks for the Johnson link, I had missed that one.

    @Cearbhall: “To me this seems like an argument as to why in certain circumstance I can justify reneging on ‘my word is my bond,’ or something along the lines of Cardinal Connell’s “mental reservation” concept.”

    The argument is more that in certain circumstances it will be in my interest to renege. If we assume that agents are self-interested (as cynical/realistic economists always do), then they probably will renege, ex post, on an ex ante commitment in such circumstances (hence, time inconsistency), UNLESS THEY ARE PREVENTED FROM DOING SO — thus, this line of argument is used by theorists arguing, for example, that central banks should be forced to obey RULES rather than enjoy DISCRETION.

    In the context of this issue, the costs of not reneging ex post are so enormous that it seems implausible to assume that governments would ever stick to ex ante rules. The logical implication is that we need much tighter regulation, and (as Johnson argues) much smaller banks.

  12. Brian O' Hanlon Says:

    @ Mick Costigan,

    Jane Jacobs links, smashing! Totally new to me too.

    Have you investigated Annalee Saxenian’s work ever? Her website is packed with great essays and papers.

    http://people.ischool.berkeley.edu/~anno/

    IT conversations has a great podcast interview with Saxenian too.

    http://itc.conversationsnetwork.org/shows/detail1777.html

    I linked the podcast before here, I think Iulia found it of benefit.

  13. Mick Costigan Says:

    @ all

    Nice cartoon in the Telegraph captures the genesis of our current position in the doom loop:

    @Brian O’Hanlon
    Happy to spread the gospel of Jane. I would love to see this work get more scrutiny, awareness and improvement. I think there may be a there there. Let me know where it takes you.

    On Saxenian, her work is very important in the San Francisco Bay Area where I am living and she has connections with the place where I work but I have not delved deeply into her work. Will remedy that. Thanks for the links.

  14. Mick Costigan Says:

    Sorry here’s the cartoon:
    http://www.telegraph.co.uk/finance/alex/

  15. Mick Costigan Says:

    Apologies again, it was yesterday’s:
    http://www.telegraph.co.uk/finance/alex/?cartoon=6748527&cc=6718600

  16. Cearbhall O Dalaigh Says:

    Re: The need for much smaller banks.

    Here is an interesting commentary by James MacGee of the Federal Reserve Bank of Cleveland. Mr. MacGee is an associate professor at the University of Western Ontario and a research associate at the Federal Reserve Bank of Cleveland.

    While subprime lending also increased in Canada, the subprime market remains much smaller than in the U.S.
    Also, bank capital regulation in Canada treats off-balance sheet vehicles more strictly than the U.S., and the stricter treatment reduces the incentive for Canadian banks to move mortgage loans to off-balance sheet vehicles.

    Why Didn’t Canada’s Housing Market Go Bust?
    http://www.clevelandfed.org/research/commentary/2009/0909.cfm

  17. Brian O' Hanlon Says:

    @ Cearbhall,

    Thanks as always for the links. Canada is a very country to study.

    I can see how Brazil would be different, Spain had mixed luck and Australia has its commodities boom. But Canada shouldn’t be so radically different from other Anglo Saxon type of societies. Yet it has fared very better in recent times.

    Is there something about Canada which lends itself better to long term thinking? If you look at its approach to health care, its approach to buildings and renewable energy. I know it might be ‘boring’ stuff. But anything is better than the deep do-do Anglo Saxon society has waded itself into in recent times.

    Canada has been making a lot of very good, though quiet progress in the high tech sector also. Back when I used to follow events in technology more closely I could see this. It is kind of like a ‘Finland’ except much, much larger.

    I was thinking a bit today. We are quite good at implementing stuff and get the production line up and running in the western economies. But when the production line goes down, my observation has been, we are short of people in authority with a vision to re-organise and re-orient. I am getting into Marshall McLuhan kind of territory here - he was a Canadian too with a broad, expansive vision of the future.

    It is not only that Ireland has hit a brick wall. More to the point, when Ireland was never going to respond in any useful fashion if it hit a brick wall. Ireland was always going to ‘freeze up’ in this kind of a situation. The kinds of human resources we need at the top, in this situation were never available at any time.

    I don’t refer to politicians either. I am referring to people in Ireland who have been successful in business. I am reminded of a famous quip by Steve Jobs - the reason he doesn’t get along with other CEO’s - none of them have ever taken LSD.

    That is not a criticism of people at the top. Rather it is an observation, their strengths seem to lie in areas of implementation and process. I don’t have an answer beyond this. I don’t even know if it is a huge fault in our system. But we certainly do need ‘planners’, people who can create a big vision and pull resources towards them very fast, in order to create some movement.

    I find it hard to take cheap shots at the climate change concerns, good science or bad science. It doesn’t matter whether or which about climate change in my opinion - the fact is, that environmental concern groups seems to attract a brand of thinker who are good at thinking their way around big, blue sky ideas.

    That is exactly the the trait that was gradually ‘bred out’ of people who are successful in business in Ireland. It needs to come back in.

    I watched a program about the Dublin horse show at the weekend. It made some comments about the Irish half-breed stock. My own knowledge about horse show jumping is that Irish draught horses, working horses belonging to farmers supplied a lot of the ‘quality’ in show jumping horses in the 1970s. But we decided to export it all on the hoof and take the quick buck. The TV program compared it to selling the family silver.

    Now Ireland has to go to places like the Netherlands to find the right horse breeding stock.

    In Ireland, we have to think about the way we go about setting up organisations. As I tried to indicate in one of my posts here:

    http://www.irisheconomy.ie/index.php/2009/12/07/climategate/#comment-27185

    We really need to do some base level thinking through our own problems. I saw an advertisement in the newspaper today, the department of Entreprise, Trade and Employment is offering money to businesses to keep people in employment. Which begs the question, what kind of employment are we hoping to keep people in, if it has to be subsidised?

    This is only the official segment where an actual subsidy is being paid officially. But what about all of the un-official employment, which is in effect subsidised by lending or by the state?

    In that environment one cannot hope to breed the right kind of ’show jumper’ over a period of time. Very much the opposite.

    That was the point I tried to make in the ‘Climategate’ discussion. We do need those blue sky thinkers - but we also need our ‘implementers’ to engage with them. We need people to engage.

    To get the blue sky ideas whittled back down to something practical and appropriate in scale. Beyond that, I can’t see much further.

  18. Brian O' Hanlon Says:

    The summary of the above. There are some perfectly good arguments floating around at the moment, offered by people who are skeptics of much to do with Copenhagen summit and the whole environmental cause. However, my biggest fear is (something I have only recently began to suspect) is that in Ireland we are not skeptics on climate change science. We are merely skeptical about anything which involves a big, broad, expansive vision. Therein lies our problem. We may have painted ourselves into a corner.

    Taking ‘cheap shots’ at the big vision is always fun and quite easy to do. It is a very good position from which to defend oneself in an argument. That is important in a nation of conversation-alists like the Irish. To find an easily defend-able position in an argument. Much more important than finding the truth or getting to the heart of the matter. It is interesting too, that many Irish people return from Canada home to Ireland. If for no better reason, than they cannot find someone to have a good argument with.

  19. Pat Donnelly Says:

    Power corrupts

    Banks are useful, but when we depend on easy cheap credit for consumption, then we are in danger territory. When we gamble with housing flipping to others the greater later fool, we are way into the danger zone!

    Then we get governments involved!!!!!! Hello! I want to get off the bus right now!

    And yet this kind of insanity is often justified by “economists” especially of the PTB kind like Krugman. The decline and fall of western civilization! Not merely an Anglo-Saxon problem. Maybe that is a good thing. Maybe the NWO people have a plan that does not involve tremendous wasteful disruption allowing some dingbat into power?

  20. Brian O' Hanlon Says:

    One observation I have made in the past year since all hell broke loose regarding finance, politics, construction, law courts etc.

    Many of the people I know who had earned enough to set some aside, those who had built up savings, are extremely worried about their savings and look for other ‘places’ to hide them. I.e. In some form of solid asset.

    While on the other hand, people who never saved a brass penny for the last ten years have suddenly taken up the habit. It is similar to watching someone who doesn’t exercise suddenly becoming a fanatic. It is a passing fad though and by the new year, olds habits will have returned. It is quite funny to watch though, someone trying to convince themselves they can turn a new leaf. But the basic reason that some people don’t save money, is because their earning capability is too low to allow them the luxury. Plain and simple.

    I witnessed a weird kind of ‘inversion’ of behaviours at the height of the Celtic Tiger building boom also. Back in August 2009 I blogged something about it at designcomment blog. What it tries to account for, is the unpredictable nature of economics and participants in the ‘game’. You sometimes meet tipping points, when everything in the game changes, no always for the best.

  21. Brian O' Hanlon Says:

    Far Away Hills

    http://designcomment.blogspot.com/2009/08/far-away-hills.html

  22. Brian O' Hanlon Says:

    @ Cearbhall,

    I read through the paper on Canadian mortgages late last night. Of all the lines which struck me, was this one in particular, the last line.

    “The Canada-U.S. comparison does, however, highlight the practical challenge facing policymakers in assessing whether a rapid run-up in asset prices is a bubble or a “sustainable” movement in market prices.”

    It is worth ‘fleshing out’ a little bit on what is meant by a ‘policy maker’. Because to my knowledge, politicians come and go. Governments come and go. But policy has to limp on and try to push for progress with the assistance of departments, public service and outside think tanks.

    I wanted to draw attention to think tanks in particular here:

    http://www.irisheconomy.ie/index.php/2009/12/07/climategate/#comment-27185

    Think tanks always have a bun in the oven. It is like on TV cookery programs, here is one I made earlier. The politician may be just elected, so he rushes out a ‘brief’ of what he wants to the local corner store ‘think tank’. They whip together something from the ingredients that they have to hand and send it by dispatch. Then the politician proceeds to unveil the freshly baked creation for the TV camera.

    The truth is the think tank I referred to in the above link, had baked their cake on carbon taxation 12 months ago. Lets hope its one of those fruity cakes that does better with age.

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