The murkiness of ‘moral hazards’

derivatives1The Sydney Morning Herald’s Kate Jennings first heard the phrase “moral hazard” when writing speeches for a JP Morgan executive in the 90s. She asked if he made it up. The executive explained it was an insurance industry term – if a house is insured, appropriate care might not be taken to stop it from going up in flames – that had migrated to banking.

In this context, when bankers know government will save their franchise – their bacon – they will become careless in regard to due diligence and risk assessment.

The concept of moral hazard was formulated by insurers in the 1600s, but the phrase didn’t come into use until the 1800s. At first it had pejorative connotations, with the moral hazard of insuring dubious characters and certain ethnic and social groups. The Merriam Webster defined it as: “The possibility of loss to an insurance company arising from the character, habits, or circumstances of the insured.”

With time, its use became more value-neutral, showing up in banking in the 1920s when deposit insurance was first considered. In the 1960s economists latched onto the term which, these days, can be found wherever risk is offloaded. A good argument can be made that moral hazard enabled the mortgage industry to lower its standards because brokers could pass the risk to lenders, lenders to banks, banks to investors. No one thought themselves responsible. No one had any skin in the game.

Time and again, argue moral-hazard fundamentalists, both Republican and Democratic administrations have ignored moral hazard and averted financial sector crises by one means or another, and time and again the only lesson that bankers have learnt is that they pay no penalty for bungling. These bail-outs have rendered them not just reckless but stupid about risk.

Read Jennings’s full article – The banker: Once a financial anchor – at The Sydney Morning Herald …

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