I have argued that the degree to which we can intervene into financial markets depends, in part, on the degree to which the intervention will cause moral hazard problems in the future. My argument has been that we should intervene now, and then use regulation to prevent moral hazard problems from arising in the future. Thus, this brings up two considerations that should guide policy interventions. First, how much moral hazard will there be in the future if we intervene today (using an intervention strategy that attempts to construct incentives that limit this problem)? If the answer is that very little moral hazard is created, then intervening now is not very costly, at least not from a moral hazard perspective. If the answer is a lot, then the second consideration comes into play.
The second consideration is how much moral hazard can be reduced through changes in regulation. Even if intervening potentially creates a big moral hazard problem, if there are ways to change the regulations or the rules about how problems will be addressed in the future (with commitment) that substantially reduce moral hazard worries, then intervening now is also less costly.
The article below has more on the moral hazard problem based on a discussion of how the 125-year-old Bagehot's doctrine can be applied to today's financial crisis. One conclusion is that "The important extent of asymmetric information in this market points to a severe [moral hazard] problem."
The severe moral hazard problem is induced by a severe asymmetric information problem. Does the asymmetric information problem also limit the ability of regulators to reduce worries about moral hazard in the future? It can, and if regulators cannot help with the moral hazard problem in the future, then our ability to intervene today to solve problems is more limited. For example, this is from "Recent Developments in the Theory of Regulation," by Mark Armstrong and David Sappington, The Handbook of Industrial Organization, 2005:
This chapter has reviewed recent theoretical studies of the design of regulatory policy, focusing on studies in which the regulated firm has better information about its environment than does the regulator. The regulator’s task in such settings often is to try to induce the firm to employ its superior information in the broader social interest. One central message of this chapter is that this regulatory task can be a difficult and subtle one. The regulator’s ability to induce the firm to use its privileged information to pursue social goals depends upon a variety of factors, including the nature of the firm’s private information, the environment in which the firm operates, the regulator’s policy instruments, and his commitment powers. ... However, ... a regulator with strong commitment powers typically can ensure that consumers and the firm both gain... But when a regulator cannot make long-term commitments about how he will employ privileged information revealed by the firm, the regulator may be unable to induce the firm to employ its superior information to achieve Pareto gains. Thus, the nature of the firm’s superior knowledge, the firm’s operating technology, the regulator’s policy instruments, and his commitment powers are all of substantial importance in the design of regulatory policy. ... Another central message of this chapter is that options constitute important policy instruments for the regulator. It is through the careful structuring of options that the regulator can induce the regulated firm to employ its privileged information to further social goals. As noted above, the options generally must be designed to cede rent to the regulated firm when it reveals that it has the superior ability required to deliver greater benefits to consumers. Consequently, it is seldom costless for the regulator to induce the regulated firm to employ its privileged information in the social interest. However, the benefits of providing discretion to the regulated firm via carefully-structured options generally outweigh the associated costs, and so such discretion typically is a component of optimal regulatory policy in the presence of asymmetric information.
Here's the discussion of how the 125-year-old Bagehot's doctrine can be applied to today's financial crisis, and how it relates to the moral hazard problem:
Bagehot, central banking, and the financial crisis, by Xavier Vives, Vox EU: The present financial crisis poses two main questions: whether it is similar to past crises and how central banks should intervene to preserve the stability of the system.
The current financial turmoil seems extraordinary because it has unexpectedly affected the heart of the functioning of our sophisticated money markets. Despite the Northern Rock episode, the main contours of the current crisis seem very distant from scenes of crises past where newspapers were covered with photos of depositors queuing to withdraw their money during a panic. Yet this crisis is just a modern-market form of a traditional banking crisis.
An old-fashioned bank run happened if enough people tried to withdraw their funds from a bank; even if the bank was solvent, it might not be able to meet all the withdrawals and thus the fear of bank failure could become a self-fulfilling prophecy. In the current crisis, participants in the interbank market take the place of long queues of withdrawers. They have stopped extending credit to other banks that they suspect to have been contaminated by the subprime loans and which therefore may face solvency problems. The commercial bond market and structured investment vehicles are facing similar trouble.
Both the old and new forms of crisis have at their heart a coordination problem. In the current one, participants in the interbank market and in the commercial bond market do not renew their credit because of fear others will not either. Witness the demise of the investment bank Bear Stearns at the heart of the dealing on structured vehicles.
In reaction, central banks have intervened massively, injecting liquidity and allowing banks to access fresh cash at the discount window in exchange for collateral that includes the illiquid packages of mortgage obligations. Have central banks done the right thing or are they provoking the next wave of excessive risk taking by bailing out banks and markets? Is monetary policy the only tool available for the central bank to address the market crisis?
Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls. It makes clear that discount-window lending to entities in need may be necessary in a crisis.
Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity
The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.
Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped.
Therefore, a key question to assess the future consequences of current central bank policy is whether the subprime mortgage crisis arises in the context of a moderate or a severe underlying moral hazard problem. The important extent of asymmetric information in this market points to a severe problem. Be as it may, this issue will determine whether current help will plug the hole for good, or only temporarily to make a larger one in the future. The challenge for central banks is to find the right balance between preserving current stability and imposing discipline for the future. Bagehot’s doctrine is still a reference today.
1 See X. Vives and J.C. Rochet (2004)”Coordination Failures and the Lender of Last Resort: Was Bagehot Right after all?” Journal of the European Economic Association (www.eeassoc.org/jeea/)