After the Bailout: Regulating Systemic Moral Hazard

Abstract:     
How do we make our financial world safer? This Article offers a strategy for regulating financial markets to better prevent the kind of disaster we have seen in recent months. By developing a model of risk manager decision-making, this Article illustrates how even "good people" acting in utterly rational and expected ways brought us into economic turmoil.

The assertion of this Article is that the root cause of the current financial crisis is systemic moral hazard. Systemic moral hazard poses a unique challenge in crafting a regulatory response. The challenge lies in that the best response to systemic moral hazard is "preventive prediction." It is inherently difficult to reward individuals for producing preventive prediction. Therefore markets fail to produce it at optimal levels, and thus prevent systemic moral hazard and the kind of crisis we are facing.

The difficulty in valuing preventive prediction is seen when we model how risk managers make decisions regarding the prevention of excessive risk. The model reveals that the balance is easily tipped in favor of risk-taking that leads to systemic failure and broad social harm. The model also reveals how regulation might work to reset the balance to one that is superior for society. We achieve this by imposing two requirements on all asset managers in the market: we require them to put their own money at risk in their trading decisions, and we require them to use "best practices" in managing risk. These prescriptions arise out of a regulatory strategy that accepts the need to balance the benefits of risk-taking in financial markets (and the consequent inevitability of some financial failure) with the desire to avoid excessive risk-taking and the costs of systemic collapse. It is a strategy that focuses on those instances where we cannot trust ourselves to be prudent.

Keywords: Regulation, Financial Markets, Financial Crisis, Bailout

JEL Classifications: K22, G28, G18, D81, D62

Accepted Paper Series