Moral Hazard

Back in Switzerland, one event I went to was sponsored by the Geneva Private Bankers association. They said that though their investments were down somewhat as a result of the crisis, they had avoided any kind of catastrophe. And the reason they avoided catastrophe, they said, was that Swiss private banks are unlimited liability partnerships. And that, they said, makes them risk averse. This is somewhat similar to the conclusion Michael Lewis reaches at the end of his entertaining and informative Portfolio article on the situation in which he suggests that the transformation of Wall Street firms from partnerships to public companies played a big role in the crisis.

That said, while you might have been able to prevent the emergence of large, publicly listed financial services firms now that the cat’s out of the bag it’s not clear to me how you would put it back in. And there are advantages to letting finance firms get big and capture some economies of scale. But I do think some of the moral hazard issues involved in this bailing out business have been getting short shrift.

Megan McArdle’s made to me the case that the movers and shakers on Wall Street have taken a bath on all this and are plenty sad as is. But I don’t think that’s quite right. For one thing, if you had $20 million stashed away somewhere and lost 95 percent of that, sure you’d be pretty sad. But you’d still have a million bucks in the bank which is a lot more than most people. And what’s more, during the fat years you’d been enjoying very high ongoing levels of consumption. Merely losing most of your savings doesn’t come close to making the overall experience a negative one — you’d need to be brought down to less than zero to make up for those years worth of high on the hog consumption slows. Specifically, to distinguish the issue at hand here from a pure quest for revenge, we need to ask ourselves what the current state of play make a titan of finance think about the way he’s been running his business. What you want is for people to look back and say “well, I wished I’d managed the firm more responsibly at the margin.” But I’m afraid the real retrospective analysis is “well, I wish I’d managed the firm less responsibly and soaked up more leverage-laden profits back when the going was good — after all, the whole thing was going to blow up anyway and I was going to come out ahead anyway.”

The conversation has sort of moved past this moral hazard point, in favor of discussion of regulatory changes. If you’re going to have bailouts, the thinking goes, then you need to have preventive regulation to make sure this doesn’t happen again. And that’s fine. But I think the more you look into this, the more pessimistic you become about the idea that we’re ever going to construct a really airtight regulatory regime. My joking proposal at dinner last night was that you let firms operate totally unregulated, but with the proviso that if your company winds up needing a bailout at some point we’ll take your family out back and shoot them.

Now, admittedly, you probably can’t do that.

But you probably can’t prevent bubbles and manias and panics either. And you probably can’t let everything fall apart just for the sake of teaching some folks a lesson. But you can try to prepare better for cleaning up the aftermath. And it seems to me that it’s essential that part of that be making people really pay a price. Not just losing a lot of money, but actually winding up worse off than they would have been if they’d never gotten into the game in the first place. Ultimately, I’m not sure that all the regulation in the world can really make up for the simple idea of caution.