To the Point, February 26, 2010


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To the Point, February 26, 2010

  1. 1. To the Point Discussion on the economy, by the Chief Economist February 26, 2010 Cecilia Hermansson Chief Economist Economic Research Department +46-8-5859 1588 No. 2 2010 02 26 Don’t underestimate the importance of moral hazard The global financial crisis and Greek tragedy have something in common: the faulty estimation of risk. The reasons why investors and creditors calculate risks badly are many, but one of them deserves more focus, viz., the moral hazard phenomenon. This version of the To the Point analyses the importance of moral hazard for actions taken on financial markets, focusing on the crises on the private financial markets and with regard to sovereign debt. There are some common aspects, but also some major differences. The discussion on moral hazard revolves around timing. As the crisis unfolded, policy action was needed in order to avoid a much worse situation in the financial sector and the real economy. The boat was sinking, and there was a need to get to the shore. On the other hand, as the financial crisis has abated there is a need to discuss more in depth the impact of moral hazard, and possibly there is something to be learnt also for the European situation, although there, crisis management must still get first in line. What is moral hazard? Moral hazard appears when an actor who is insulated from risk behaves differently than if this person or institution were fully exposed to risk. In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer. For example, a family with insurance against flood damage may have an incentive to locate their house closer to a river than a family that would bear the entire cost of a flood. Financial bailouts by governments and central banks can encourage risky behavior in the future if those who take the risks believe they will not have to carry the whole burden if losses occur. Often, one party has more information than the other, and, with the information asymmetry, the party with less information ends up taking responsibility for the consequences of these actions. Taxpayers have thus often had to finance the losses occurring from financial crises. Moral hazard can occur with banks and other financial agents acting on behalf of another party, i.e. the principal with less information, but also with borrowers who do not act prudently. There are countervailing pressures on banks that limit incentives for risk taking. Regulation and supervision are important pressures, but, if these fail, the risks of moral hazard increase.
  2. 2. To the Point (continued) February 26, 2010 2 More important, the fact that an institution can fail imposes a large cost on bank owners and managers, who then lose their jobs. In 2007, the investment bank Bear Stearns had traded for as much as 172 dollars per share, but when it was bought by J.P. Morgan Chase, the price fell to 2 dollars per share. If financial institutions are protected by governments, shareholders are not protected, but creditors are. So the focus should be on creditors and banks that take on excessive risk, thereby reducing discipline because they believe in government protection. In a vicious circle, high-risk behavior increases the chance of bank failure and bailouts by governments. Those who find the argument of moral hazard farfetched should adopt a long-term approach. Deregulation of the financial sector in the 1980s, especially in the US, with the existing inadequate supervision, created an environment where risks were taken excessively, and where resources were allocated incorrectly, causing costs for society. The financial sector grew as a result, and its profits as a share of the total profits increased from some 20% at the beginning of the 1980s to almost 50% in 2007, before the onset of the most recent financial crisis. The US financial crisis Gary Stern and Ron Feldman (both from Federal Reserve Bank of Minneapolis) wrote a book, “Too big to fail – the hazard of bailouts,” in 2004. They argued that the too-big-to-fail (TBTF) problem was getting worse, and needed immediate attention. As the financial crisis started in the US in 2007, there was a massive across-the-board expansion of financial institutions’ safety nets. The TBTF problem has become worse since then as the largest and the most interconnected firms have become even larger and more interconnected due to the support they have received. Unless the TBTF problem is reduced, there is a risk of a new financial crisis sooner rather than later. Protection of uninsured creditors of banks is the factor that underlies the concept of TBTF. Between 1979 and 1989, some 1,100 commercial banks failed, but 99.7% of all deposit liabilities were fully protected by the discretionary actions of US policymakers. Size is also important, as special protection is provided for creditors to big or interconnected banks. Over the years, creditors have believed the banks they are funding will be bailed out, and this belief has influenced the risks they have taken. When Bear Stearns was protected by J.P. Morgan Chase’s stepping in with the support of US policymakers, the financial markets were relieved, because the environment remained unchanged. When Lehman Brothers filed for chapter 11, however, the shock was immense, as financial markets had started to believe in eternal bailouts. Some time afterwards, however, policymakers had to reassure the financial markets that the pre-Lehman Brothers environment would be restored, so that confidence could return. Small and unimportant regional banks tasked with lending to SMEs and households have thus been allowed to fail, while the big ones have become even bigger.
  3. 3. To the Point (continued) February 26, 2010 3 Chart 1: Public deficits as a share of GDP, for selected OECD countries (%) -16.0 -14.0 -12.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0 Ireland USA UK Greece Spain Japan France Portugal Italy Germany Denmark Finland Sweden Source: European Commission Chart 2: 10 year Government bond interest rate spreads to Germany for selected Euro countries Source: Reuters EcoWin jan 07 maj sep jan 08 maj sep jan 09 maj sep jan 10 Percent -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 Greece Italy Belgium France Spain Portugal Sweden Source: Reuters/Ecowin Also, the borrower has been bailed out through special measures to reduce mortgage interest rates and to provide direct support to households in need. Monetary policy has also played a role over many years, as the so-called Greenspan put created an environment in which interest rates were lowered as asset markets fell but were not similarly raised as asset markets rose. This asymmetric monetary policy has come to an end, though, as the policy interest rate has already hit bottom. Mortgage loan interest rates could go lower, but not by much. As the crisis has abated, the concern for moral hazard is coming back into focus in the US. Reenactment of the old Glass-Steagall act separating investment and commercial banking has been proposed. There are those who find the elimination of the Glass-Steagall act in 1999 a trigger for the buildup of TBTF institutions. Balance sheets can always be manipulated; thus the issue of bailouts may be just as important as the split between investment and commercial banking. Professor of Economics Carmen Reinhart points to four options for solving the TBTF problem: (1) no one gets bailed out (theoretically pure, but less credible as bailouts have been common historically and contagion can be costly) (2) everyone gets bailed out and regulations are not established, i.e., the basis for a new crisis; (3) the TBTF doctrine is applied in radical steps and institutions are dismembered; and (4) credit growth and leveraging are closely monitored, and institutions are regulated according to their indebtedness. She finds that, although risk is difficult to measure, debt levels can be monitored. The only way to solve the problem of moral hazard is to create an environment in which bailouts are not expected automatically. To get there may cause more turbulence on financial markets, and thus we have not yet solved the financial crisis. The European sovereign debt crisis There are some similarities between the US financial markets crisis and the European (Greek) sovereign debt crisis. After 2001, when Greece adopted the euro and became a member of the common currency, financial markets saw the risk of giving credits to Greece fall gradually: Long-term (10-year) government bonds were just 1 percentage point above the equivalent German rate in 2007. During 2008 and 2009, this interest rate spread widened when the extent of the Greek fiscal situation became more clear, and when it was announced that the ECB stimulus measures would be withdrawn, thus reducing the possibilities of using less creditworthy Greek bonds as collateral for borrowing cheaply at the central bank. Financial markets have thus repriced the risk. Greece is still part of the currency union, but lending to Greece is no longer seen as a low-risk activity. The moral hazard problem may be hard to see here, as it is unlikely that governments would risk the future of a country that is counting on being helped out by other governments. The pain of having a financial and fiscal crisis in a country is severe. On the other hand, countries not having experienced these crises (unlike Japan, the Nordics, and East Asian countries) may underestimate this pain, and it is not until they have experienced it for themselves that
  4. 4. To the Point (continued) February 26, 2010 4 Chart 3: Real effective exchange rates for selected countries Source: Reuters EcoWin 97 98 99 00 01 02 03 04 05 06 07 08 09 Index100=1997 90 95 100 105 110 115 120 Spain Portugal Greece Italy Germany Source: BIS Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46-8-5859 1000 Legally responsible publishers Cecilia Hermansson +46-8-5859 1588 cautiousness rise and fiscal discipline increases. Other aspects that possibly better explain the lack of discipline in the case of Greece are the short-sighted political process of attracting votes, corruption and tax evasion, and the general distrust of the political establishment. The Greek government found less transparent ways of entering the EMU, had a free lunch for a few years as creditors did not calculate risks properly, and has not used the resources thus obtained responsibly. The budget deficit has risen to a level that would have been high even before the crisis, public debt has increased to more than 100% of GDP, and competitiveness has decreased since entrance into the EMU. The real effective exchange rate has appreciated by some 20% since joining the euro, and the current account deficit was already as high as 15% of GDP in 2007, before the sovereign crisis escalated. Just as in the case of the US financial crisis, it is better in the case of Greece to focus on creditors rather than governments or shareholders. The European banks lending to Greece have counted on a bailout of the Greek government, despite the explicit prohibition of such an action in paragraphs 123 and 125 of the Lisbon Agreement. To count on paragraph 122 is a bit optimistic as the Greek fiscal mess is not exogenous and therefore cannot be regarded as an act of God, like a tsunami or an earthquake. Germany has strong objections to giving any support to Greece, pointing to the Stability and Growth Pact, to which not even the big economies have adhered. The euro zone still has to come up with ways to reduce the risk of contagion to Spain and Portugal, and perhaps also to Italy, Belgium, and Ireland. Bailing out is not the first option, and to put conditions on possible future support is the best message that can be given to financial markets at this stage. I believe that, just as in the case of the US financial crisis, when the boat is still leaking, ways have to be found to bring the boat to the shore. There are too many risks connected with not doing anything at all. The best solution would be for Greece to make it on its own. But if not, there have to be ways to mitigate the crisis either with help from the EU/euro zone alone, or in combination with the IMF. When the crisis has been solved, at least as well as possible, the focus must again be on moral hazard. For Europe, it is important to find the right institutional framework that works both during relatively tranquil times and during times of turbulence. During the tranquil times, risks may be taken excessively, but with the right incentive structure, there would be less risk of creating bubbles or misallocating funds, whether on private markets or in the public sector. Moral hazard may not be the most important factor explaining the Greek crisis, but for the future of the euro this problem deserves attention. Cecilia Hermansson To the Point is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To the Point.