eFinancialCareers

What is it?

Moral hazard describes a situation in which someone or something isn’t made to suffer the consequences of their actions and therefore behaves recklessly, knowing that their actions won’t have repercussions for them.

For example, if I know there is a non-invasive operation to mitigate the effects of smoking cigarettes that’s offered cost-free by the state, I might be inclined to start smoking. Equally, if a bank knows that a government will come and rescue it when it gets into trouble, it will be more inclined to make risky loans, safe in the knowledge that it won’t be allowed to go under if the loans aren’t paid back.

What’s it got to do with the financial crisis?

Considerations of moral hazard have played a big role in the way governments have dealt with the financial crisis and in the shaping of the bailout packages they have put together.

In some cases, it is argued that worries about moral hazard meant governments failed to act quickly enough to stop the credit crunch before LIBOR soared and interbank lending on the money markets froze, leading to near meltdown. In other cases, it is argued that when governments did take measures, worries about moral hazard made those measures too punitive.

It was worries about moral hazard that led the US government to allow Lehman Brothers to fail. Equally, the US Treasury charged a punitive rate of interest – 8.5% higher than LIBOR – on the loan it made to AIG. Former US Treasury Secretary Henry Paulson invoked moral hazard so often that it became known as "the Paulson Doctrine."

The UK government also tried to attach onerous terms to its bailout of the country’s leading banks, initially requesting that the banks didn’t pay a dividend to any of their shareholders for as long as the government owned a share in them, too. However, the British government was forced to relax its stance and say that dividends could be paid after one year when it was pointed out that investors wouldn’t want to hold bank shares that didn’t pay dividends and their banks’ share prices would therefore fall even further (leaving the government with a loss on its investment).

As the crisis has become more acute, governments are increasingly having to put considerations of moral hazard to one side. Arthur Levitt, an influential former SEC chairman, argued that CDS insurance contracts against default on the bank’s debt, is now widely considered to have been a mistake. Pragmatism is now the order of the day.

For example, when Mitsubishi UFG agreed to invest $7.8bn in Morgan Stanley in late October, it apparently demanded that if the US government were also to put money into Morgan Stanley, it wouldn’t wipe out Mitsubishi’s stake. The US government agreed – in contrast to its position on Fannie and Freddie, when shareholders saw their holdings heavily diluted after the government bought $1bn of preference shares in each of the two companies.

Last updated on 7 September 2009.

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