On question that often arises from situations like the recent, unusual, drop in US interest rates and the stimulus package to support the markets is one of moral hazard. Simply put, the question is whether the tendency of the monetary regulators to respond to widespread market drops with action to push more cash into the system creates moral hazard – a willingness to take more risk in the knowledge that the US Fed (for example) will ride in on a White Charger and help.
My answer is that routine “While Charger” action certainly does create the impression that the “Greenspan Put” is a way out of bad decisions – there is always in the back of the mind the thought that the regulators will act to stop “long-tail” events.
Does this impression actually show through into the real world, though? As the market is really a series of micro events that go to make up a macro picture I would doubt it would have a large impact. To put it another way – will the thought that the Fed may act to bail out the market change the way an individual bond issuer or buyer behaves? If I am considering changing a bond position worth maybe a few million I am really going to consider the possibility of an industry wide bailout if an entire class of assets heads south? Will the thought that the Fed will change rates in the event of a general collapse change the way I trade?
Personally, I doubt it. The individuals actually trading can never really tell whether their position is going to be one of those actually rescued by a general interest rate drop or other action. The only point where this may become a thought is where there is already a widespread drop – but in this circumstance the action would be to point the dealers out of the drop, not into it.
That said, it may affect the risk appetites of the largest of players such as the really big banks, so there is certainly a risk of it. I just think it is overstated by people who look at the macro effects of moral hazard and think that the markets act as some sort of a collective intelligence, rather than looking at it as a series of micro events, which, in reality, it is.
25 January, 2008 at 20:07
Probably a good point.
If there is an effect, I would imagine it would be a lot less than the salary and bonus incentives of the individual concerned. Let’s say I know I will make a million dollars if my bet goes up 10 million, but if it goes down 10 million, maybe I’ll lose my job or earn nothing… that would be a stronger consideration than the possibility of my bad bet being bailed out by a central bank or government.
However, it is up to the people further up the chain from the individual – the company bosses – to consider the cumulative effect of all these bets, and maybe they would be more likely to be affected by the perceived guarantees of large-scale bailouts, stimulus etc? Perhaps they are more likely to approve the individual decisions with this in mind? And then there is the psychological effect of there having been so few major downturns in recent history – perhaps some downturns that were cyclically “due” have never occurred due to actions that ignore moral hazard concerns?
I’m no banker, nor an economist, so I am probably missing something. I’ve been interested in following this blog, as well as the doom-and-gloom ones, but the issue of the bonus structures for traders has perplexed me since even before the current shenanigans.
26 January, 2008 at 12:52
You are right, in that bonus structures provide a strong one way incentive towards risk taking – if the middle office and management are not doing their job. If a trader is spectacularly successful in one year he or she may earn a lot in bonuses – but if they lose money the worst that can happen is they lose their job. If most of their income is in bonuses then a big bonus is something worth shooting for. This is why most traders hate the middle office and risk management functions – they see them as getting in the way.
Traders, by their nature, will normally take on as much risk as they can, meaning the attitude to risk (provided appropriate controls are in place – see SocGen) will be set by upper management setting the risk limits of the firm. If they have in mind that the Greenspan put could be in play then they may well increase their risk limits to cover this. I tried to capture this in the last paragraph.
I do think it is overstated, though – they cannot know when or if it will occur so I just doubt it will be a major factor.