Transcript Economics and Moral Sentiments: The Case of Moral Hazard

The reform of financial regulation:
a Post Keynesian perspective
Sheila C Dow
summary argument
Reform of financial regulation is required to address:
the endemic potential for financial instability in capitalist economies
the functionality of finance
but needs to consist of more than incentives and constraints.
SCEME
University of Stirling
[email protected]
for presentation to the PKSG, Cambridge, 9 November 2010
Structure of the Argument
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Purpose is to focus more on the principles of regulation than on the
detail, and to focus on banking
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The role of financial regulation: promoting the efficiency or
functionality of the financial sector?
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Regulation in its narrow and broad senses
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Theory of banking: focus more on calculative rationality or social
convention?
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Case study: addressing moral hazard
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Policy implications: focus more on constraints/incentives or on
restoration of social conventions?
1 Mainstream Approach to Reform of the Financial Sector
1a Theory of Banking
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Banks are simply financial intermediaries, maximising profit subject to
constraints
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Market forces generally ensure the efficiency of financial institutions
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Different financial institutions are distinguished by regulation, transactions
costs and information asymmetries
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Banks in the past dominated credit supply because they enjoyed
information advantages from managing deposit accounts
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Banks benefited from regulation to protect depositors, which created moral
hazard re lending
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Confidence/trust in banks is the outcome of a rational calculation
of risks
1b Mainstream Approach to Financial Regulation
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Market forces produce the best outcome, cet par
Free Bankers/New Monetary Economists: extreme free market
position - no role for regulation
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Washington consensus I: financial liberalisation
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Washington consensus II: improve governance
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New Keynesians: regulation to address market imperfections
1c Moral Hazard in Mainstream Theory
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The unintended effect of insurance as increasing the willingness to
take on risk (with limits on monitoring)
Origins in insurance literature: implied moral judgement
Developed in decision theory as the outcome of the rational pursuit
of selfish ends, ie opportunism
Credit rationing literature: moral hazard arises from rational
response to asymmetric information
No ethical connotation to term ‘moral’ hazard: ‘moral sentiment’
meaningless
Moral hazard was only identified once the crisis emerged
1d Mainstream Approach to Policy to address Moral Hazard
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The problem: moral hazard - rational opportunism in response to
incentives has unintended consequences for the financial system
and confidence in it
The solution:
 Don’t discourage rational behaviour
 Free Bankers: remove all other state interference
 New Keynesians: if accept that market imperfections are
inevitable:
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improve governance by the state, and by banks, and
Regulate against risky opportunities
Change the incentives (eg terms for bonuses)
Reduce LOLR protection: banks small enough to fail
But none of these will successfully restore confidence if the potential
for financial instability is endemic
2 Post Keynesian Approach to Reform of Financial Regulation
2a Post Keynesian Theory of Banking
(drawing particularly on Victoria Chick’s work)
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Banks are agents of the state (as principal), providing society’s payments
system
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The emergence of bank liabilities as money was the product of confidence
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This allows credit creation, so banks are not just financial intermediaries
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Emergence of role of central bank in promoting confidence in banks
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Lender-of-last-resort facility (LOLR) intended to reduce systemic risk in both
senses (interconnected portfolios and confidence in banking)
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Normally this takes the form of supplying liquidity to support bank rate
rather than active support of individual banks
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Functionality of banking declined from stage 5
as a social convention
Evolving Tensions in Banking
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LOLR increases confidence but reduces central bank leverage on
credit creation
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Both cooperation and competition between banks: importance of
interbank market
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Confidence in banks is lower the more free is competition and thus
exposure to risk: the natural tendency of banking is to concentrate,
increasing market power
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Increasing confidence in banks allows reduced reserve ratio,
increasing their vulnerability
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Fractional reserve banking is inevitably potentially fragile
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Banks vulnerable in crisis situations to collapse of confidence in
Keynesian sense: CARs inadequate protection
Role of social conventions re confidence
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Institutional structure and social convention provide foundation for
economic activity
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Includes social conventions with respect to asset valuation
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Trust provides basis for (non-calculative) confidence
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Moral values are a necessary element of successful activity
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Immoral/opportunistic behaviour undermines socio-economic
structures
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Immoral/opportunistic behaviour undermines the functionality of
banking
2b Post Keynesian Approach to Financial Regulation
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The financial system works best as a decomposable system
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Aim of promoting functionality of finance against backdrop of inevitable
potential for financial instability
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Functionality refers to provision of credit and liquidity according to society’s
needs
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Need to build on social conventions, which build on history, to strengthen
social structures in finance (cf régulation approach)
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Segmentation + sand-in-the-wheels to moderate tendencies for swings in
market sentiment and thus leverage (reducing efficiency in mainstream
sense)
Need for non-calculative confidence in money to underpin the financial
sector and commercial society
2c Moral Hazard in Post Keynesian Theory
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Morals are relational: concern here is with the structure of finance in
relation to society and thus with ethics, rather than personal
morality in an atomistic sense
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Moral hazard at a micro level is uncertainty about the honesty or
prudence of the other party (person or institution)
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It is broader than active concealment of information: full
information is not available anyway
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So decision-making under fundamental uncertainty requires
confidence in others’ behaviour and in institutions
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Moral hazard at the societal level is the risk that social conventions
will weaken, eroding trust
Moral Sentiment and the Financial Sector
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The central role in the crisis of market sentiment is an epistemic
issue, but euphoric market sentiment can encourage opportunism
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Financial companies are social entities
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Sense of fairness and social responsibility are important drivers (not
just profit); opportunistic behaviour not to be assumed as the norm
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Ethics and profitability not mutually exclusive
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But conventions can evolve which are immoral eg Enron
(misrepresentation of information, not just concealment) and banks
encouraging customers to be imprudent
Regulation (by government or professional bodies) can put some
bounds on immoral practices
Evolution of the principal-agent relationship
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Traditionally, banks’ portfolio behaviour was constrained and
monitored as a quid pro quo for LOLR
Change in social character of this relationship: substitution of
regulation for gentlemen’s agreement due to globalisation in
banking
Relaxation of regulation from the 1980s legally freed up banks
as agents to accept more risk: moral hazard on the part of
banks
Reduced monitoring and supervision, and then the possibility of
the central bank not guaranteeing LOLR led to loss of confidence
and focus on agency/trust issues: moral hazard on the part of
the central bank
2d Post Keynesian Policy to address Moral Hazard
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The problem: need to rebuild trust, to create a climate of
confidence, in banks and central banks
Prevent narrow moral hazard by simple regulatory restrictions in line
with traditional banking culture:
 prohibit some activities (eg proprietary trading) and
 apply simple regulations (eg liquidity ratios, rules on mortgage
lending and eligibility for credit cards)
 But take care: restrictive regulation can create new types of risk
in a dialectical process (eg CARs)
Reassert LOLR for traditional banking, to prevent moral hazard of
central banks
Establish global insurance fund and/or Tobin tax to support LOLR in
case of systemic risk
Some Issues
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Fragility of fractional reserve banking
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Should confidence in money be guaranteed by 100% reserves (narrow
banking) or in a state-run gyro system?
But this removes the special capacity of banks to create credit and
encourages alternative assets to be used as money
Non-bank money
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The liabilities of shadow banks may seem perfectly liquid as market
sentiment picks up, but will lose liquidity in downturn again and not be
covered by LOLR
Can this be handled by more clarity over deposit insurance and LOLR?
Could the central bank ensure enough liquidity through the repo market
to avoid recourse to alternatives? But then should the central bank
restrict liquidity to discourage excessive asset price rises?
Addressing Broad Moral Hazard with ‘Broad Regulation’
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The aim is to change behaviour and attitudes, ie financial culture,
through changing the structure of the financial sector
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Design this structure on the basis that socially-aware behaviour is
inevitable and other-regarding behaviour is not irrational
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Increased emphasis on governance
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Checks on management of banks: active monitoring and supervision
Checks on management of bank regulation, supervision and monitoring
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Active support for social/cooperative/ethical banking
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Active socialisation of banking:
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improve government knowledge of the financial sector for early
identification of culture problems
provide a vehicle for promoting a more ethical culture.