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Ch10SystemicRiskrevised.ppt

CHAPTER 10

Moral Hazard, Systemic Risk & Bailouts

CORPORATE GOVERNANCE

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Chapter Overview

  • Systemic risk and moral hazard
  • History of bailouts due to systemic risk
  • The financial crisis of 2007-2009
  • Governance failures as a cause of the crisis
  • International perspective

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Systemic Risk and Moral Hazard

  • Systemic Risk – The risk that one key firm failing will cause a chain reaction throughout the economy (i.e., firms are “too big to fail”)
  • Moral Hazard – If a firm knows the government will bail them out, they have an incentive to take extra risk

If the risky situation pays off, the firm prospers

If there is a poor result, the firm does not suffer the full loss because the government will prevent bankruptcy

  • Note: moral hazard also applies to individual decisions like a CEO taking high risks because she knows the government will step in if things go wrong

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History of Bailouts

  • During the Great Depression, the economy contracted severely causing record unemployment and a large number of corporate and bank failures.
  • Ever since, economists have debated actions that might have limited the severity of the Great Depression.
  • One solution is to prevent key firms or banks from going bankrupt because this would stop the “domino effect.”
  • Over the years, there have been several such bailouts:
  • U.S. Auto Industry (late 70’s to early 80’s)
  • Long Term Capital Management (large investment fund) (1998)
  • Airline Industry (2001)

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Bailouts in the Banking Industry

  • Banks play a key role in the economy because bank lending acts as a multiplier for the money supply
  • If banks stop lending or are forced to call in loans, this has a direct effect on growth in the economy
  • Companies whose loans are called may not be able to replace the financing, forcing them to close
  • Companies seeking to expand will not get loans
  • Government response – federal guarantees of customer deposits and federal intervention to prevent one bank failure from spreading to others

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Governance Failures: Investment Banks

  • How could Bear Stearns and Lehman survive the Great Depression, but not this crisis?

Compensation scheme for top employees rewards taking risky positions

Cost of firm failing falls on shareholders and not on managers who earned hundreds of millions in bonuses from taking high risks in a single sector of the economy

Investment banks were partnerships during Great Depression which meant the managers were also the owners. In 2008, they were public companies with a small fraction owned by managers and top employees.

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Governance Failures: Commercial Banks

  • Banks relied on credit default swap (CDS) contracts as loan insurance, so they could move loans off their balance sheets and make new loans backed by the same capital
  • Executives approved this increase in leverage because of the fees earned from new loans, which led to high bonuses
  • When financial markets collapsed and many CDS contracts became of questionable value, banks fell below minimum capital requirements and required bailouts
  • Shareholders were the big losers, as the equity value in many banks was wiped out

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Moral Hazard and the Financial Crisis

  • Did executives in financial companies take extreme positions in mortgage loans because their companies were “too big to fail” or because of their compensation contracts?
  • Compensation Contract: High bonus for high profit and zero bonus for loss

Best strategy over many years is high risk/high reward

  • Moral Hazard: the company receives the benefits from the risky strategy; the government bears the cost if things go wrong
  • It is hard to separate the two effects in the financial crisis of 2007-2009, because they both explain extreme risk-taking (i.e., betting the company on residential mortgages)

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International Perspective

  • Due to the international nature of financial markets, the financial collapse in the U.S. had a worldwide impact:

Many international banks and investors owned large investments in bonds backed by U.S. mortgages

CDS contracts were international as well (AIG paid ~$58 billion to overseas banks to settle CDS contracts)

  • Other countries enacted their own bailout packages to try to avoid a spreading financial collapse.

UK bank rescue plan totaled $850 billion

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International Perspective (Continued)

  • Is all the concern about a “domino effect” justified?
  • The experience of Iceland in the recent financial crisis suggests that it is:
  • All three major banks in Iceland failed following a “bank run” on one bank that spread to the others
  • Iceland’s currency and economy quickly collapsed soon after, with the stock market losing 90% of its value
  • The speed and severity of this collapse shows how interconnected the global financial system is

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Summary

  • In response to financial market failures triggered by falling housing prices, the U.S. government bailed out many firms to try and avoid a major financial collapse
  • Most of the failures that led to bailouts can be traced back to poor corporate governance, as firms had bet their companies survival on a single sector of the economy
  • Were these high-risk bets due only to perverse incentives in compensation contracts, or did moral hazard play a role? The effects are hard to separate.

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Summary (continued)

  • When firms are “too big to fail,” some firms appear to take actions that transfer the risk of bad outcomes to the government (and ultimately to taxpayers)
  • The experience of the Great Depression and of Iceland in 2008 suggest that allowing for cascading failures (the “domino effect”) in financial markets is much worse than governments stepping in to bailout firms that are “too big to fail”

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