Moral hazard 101 November 9, 2012 at 8:48 am

Some people seem not to understand why it is a bad idea for a regulator to want to reduce the size of a market. It’s simple: there is enormous moral hazard in that.

Suppose politicians say something is illegal, and legislate. Then you can’t do it any more. That’s clear, but it is NOT what has happened with EMIR. EMIR, remember, is the European Market Infrastructure Regulation (well, it has a longer title now but that is what gave it the name) – it is about how you must trade, and in particular when you must clear some trades (and report them to trade repositories etc.) EMIR, in other words, does not tell you what you can and can’t do, just how you must behave once you have done it. It does not give a regulator the right to aim to reduce the size of a market: it gives them the tools to supervise its activity. Those two things are very different.

It is important to understand that there is a boundary to what society permits supervisors to do. They can and should enact rules to correct negative externalities within the agreed legal framework. They should not become bank managers, dictating strategy, because that makes them responsible for everything that banks do. If you say `a market needs to trade this way, with these safeguards’, then you are regulating; if you say `this market should be bigger and we will make it so’, then you are responsible for the economic and social effects of that market. That is not something that any supervisor should want, and not something society has empowered them to take: we leave that to politicians.

Note that there is a clear regulatory arbitrage in turning a swap into a future. I don’t mean trading exchange traded interest rate futures instead of swaps, I mean producing a bilateral OTC future with the same value as a swap. By simply writing future rather than swap, you reduce capital requirements (1 rather than 5 day MPOR). If your policy aim is to create more futures and fewer swaps, then success might be just a rebranding. That is not effective regulation – it is an unintended consequence of regulatory over-reach. It is exactly the kind of thing that happens when supervisors try to become CEOs instead of rule writers.

5 Responses to “Moral hazard 101”

  1. great post, i am totally aligned with you on this. just to play devil’s advocate though, wouldn’t this same argument suggest risk based capital requirements should be scrapped? after all, if supervisors are throwing around capital incentives to inflate/deflate markets somewhat arbitrarily through a blunt backward looking view (think housing/correlation trading, respectively) isn’t this the same thing as saying it outright as is the case with your conference friend?

  2. Thanks Mick. For me it is partly an issue of conspiracy vs. cock-up. IRC models for the correlation book or B2.5 for (some) securitisations achieve their result* by accident; saying `we want this to be smaller’ is design. Now if your job disappeared as a result the distinction may seem a little thin, but it does matter not least because if something is done by accident, it can potentially be corrected if a sufficiently good case can be made.

    *Their result, of course, is that this risk has mostly moved to hedge funds.

  3. I can very much see the moral hazard point, but isn’t macropru regulation about heavily influencing what sectors of the economy are to be favoured or not? I think regulators have been quite clear in acknowledging that, insofar as they accept trying to take a punchbowl will be unpopular. So would you be against activist macropru?

  4. Hmmm, interesting question QM, thank you.

    If I can rephrase it a little, you are saying that even though macropru might be phrased as being about financial stability (taking away the punchbowl from banks), in practice it effects the real economy (and indeed it wouldn’t be much good if it didn’t). By raising, say, the countercyclical buffer you are in practice reducing the leveraged loan market.

    I have no problem with this, though, because you are not saying `no more leveraged loans’, you are saying `more capital please’. The former would be illegitimate for supervisors (although a perfectly reasonable position for a politician); the latter is fine.

    Perhaps a sports analogy might help. The referee can award a free kick if he sees a foul. (I wrote `fowl’ the first time and had visions of a giant chicken walking across the pitch.) That gives an advantage to one team. But he doesn’t tell them where to kick the ball, nor does he suggest that they’d do better if they substituted their left back. Similarly some decisions are properly supervisors to take; some are for banks.

    We have (with some misgivings) become comfortable with that enormous market manipulation that is central banks setting interest rates. Macro pru is in the same vein. Both things have to be done honestly, with the needs of the whole economy in mind. Greenspan received a lot of condemnation after the fact for the great moderation – he regularly features in lists of the top ten people responsible for the crisis. So the final part of the puzzle is responsibility: those taking the rate or macropru decision should be held accountable for the consequences of their actions. A great central banker deserves a lot of praise, but a bad (as opposed to unlucky) one deserves to be fired by their political masters.

  5. QM – One more thing, sorry. Macropru has been signed off by politicians, so they have delegated that authority. For a supervisor to decide to do macropru without such political cover would be another thing entirely.