Financial crisis: the moral of the story


The crash of 2008 triggered a wave of bailouts, making ‘moral hazard’ a key phrase among commentators. As Cyprus is made to fund its own rescue IBA Global Insight assesses whether the term has finally found purchase in the financial system.

Tom Bangay

‘I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers.’ In 2008 Hank Paulson, then US Secretary of the Treasury, faced the prospect of making the average American pay for Lehman’s reckless mismanagement and reimburse the doomed investment bank as it stood at the brink of insolvency. Paulson deemed the ‘moral hazard’ too great.

Why should taxpayers continually foot the bill for the finance industry’s risk-taking? The dominoes fell, and the decision became fateful as it passed into financial crisis folklore, but with every subsequent bailout, from AIG and Hypo Real Estate through to Greece and most recently Cyprus, the tension between moral hazard and ‘too big to fail’ looms large in the thinking of those pulling the macroeconomic levers.

The issue is simple: if one party knows that it won’t bear the costs of its risky behaviour, what incentive does it have to act prudently?

Put another way, if a gambler knows his debts will be paid, why would he ever stop making wild bets? If a central bank bails out a financial institution, or a sovereign state, they send a message to its contemporaries that risky behaviour won’t have consequences for the party itself. ‘Big companies will always find a way of externalising the risk,’ explains Leif Wenar, Chair of Ethics at King’s College London, ‘and it’s difficult to find the individuals most responsible for externalising that risk’. If companies, or sovereigns, can take risks and have someone else (ie, the taxpayer) pay for them, they have no reason to be prudent. Central banks can’t afford, so the logic goes, to set that example. Therefore, to avoid creating moral hazard, every now and then a bank has to fail, to preserve the credibility of the system. In the case of the eurozone, it’s countries themselves that face failure.

‘How does a society look when it's getting out of a crisis? Do we react with vindictiveness and vengefulness? Or do we accept that there was gullibility and weakness of judgement, and try to improve that’

Philip Wood QC
Special Global Counsel, Allen & Overy

It’s an idea supported by the evidence. In 2011, the International Monetary Fund (IMF) published a research paper, The Dynamic Implications of Debt Relief for Low-Income Countries, which looked at the effects of debt relief on a range of countries, particularly Uganda, and found GDP to be ‘on average lower by more than 20 per cent when the country expects a debt write-off as compared to a situation when it does not.’ Without a default of some description, countries – like companies – just never learn. Otmar Issing, President of the Centre for Financial Studies and a former member of the European Central Bank’s executive board, agrees, urging in the Financial Times that ‘default must be a credible threat – otherwise investors will have a strong incentive to buy bonds offering higher interest rates without taking into account the associated risks’.

So far, so consistent. The problem arrives when ‘moral hazard’ runs into ‘too big to fail’. What if the risk-taking actor is a global insurance giant, so inextricably bound up in the financial system that its collapse would represent a genuine systemic risk to the markets themselves? When the Federal Reserve sanctioned AIG’s $85bn credit facility, just days after deeming any state assistance for Lehman to be too morally hazardous, eyebrows were raised. Morality shouldn’t be relative; if such a doctrine is to have any weight at all, shouldn’t it be applied consistently?

Consistency hasn’t been a watchword for the series of rescue packages delivered to companies and states in recent years. Lehman, Washington Mutual and Wachovia fell. Meanwhile, AIG, Citigroup, Fannie Mae and Freddie Mac found safety in the arms of government stewardship. Merrill Lynch was forced up the aisle in a shotgun wedding with Bank of America. In Europe, the list of casualties includes major companies and sovereigns; from Hypo Real Estate, Bankia, Northern Rock and Dexia to Portugal, Ireland, Greece (three times) and now Cyprus, bailouts have been deemed unavoidable in an alarming number of cases. Small wonder that the President of the Bundesbank, Jens Weidmann, worries that ‘central bank financing can become addictive like a drug’.

Too big to fail vs moral hazard

The post-Lehman world order recognises that some entities are too critical to the global financial system to be allowed to collapse. If AIG fell over it would take much of the stock market with it; similarly if Greece defaulted and left the euro, voluntarily or otherwise, the credibility of the currency itself would be at risk. The resulting situation left taxpayers in an uncomfortable position: ‘The unwillingness to allow big banks to fail meant that the public sector was shouldering a substantial amount of risk, whilst a rather small number of individuals were reaping extraordinarily large rewards,’ explains Roger McCormick, visiting professor at the London School of Economics (LSE) and a member of the IBA’s Task Force on the Financial Crisis. So how do we reconcile ‘too big to fail’ with moral hazard? As one leading expert puts it, ‘how do we protect shareholders from corporations and their managers acting in a way which is motivated by personal greed, to the detriment of shareholders and creditors?’

The term ‘moral hazard’ itself is borrowed from the insurance industry, as Peter Mann, partner at Clayton Utz and Chair of the IBA’s Insurance Law Committee, explains. ‘If a client is protected from risk by insurance, then he might act in a risky way. It’s the result of an information asymmetry. If the insurers knew what the client did – if they could observe him – they would probably adjust their prices to reflect his risky behaviour.’ Moral hazard in insurance can also relate to the subjective aspects of risk that would influence the insurer in its decision whether to enter into the insurance, and on what terms. ‘It could involve the honesty or activities of the insured,’ Mann explains. ‘For instance, the insured might be a dishonest person involved in criminal activities. This elevated risk would be a matter for disclosure and again there is likely to be an information asymmetry. ’

Take the average driver. He wants insurance for his car. He presents himself as a careful driver to the insurer who, based on these representations, comes up with a price for the premium. However, once he’s insured, he drives differently; less care is taken, and more risk, because the driver knows that if he has an accident, or leaves the car unlocked, he’s covered. The version of himself he presented to the insurer isn’t the version that drives the insured car. Only if insurers could perfectly observe how insured parties really behave, once they’re covered, would there be symmetry of information on both sides, a fair price, and thus no moral hazard.

Could observation and monitoring be the answer for the financial system? ‘If the behaviour could be monitored directly, it would be possible to write complete contracts and the moral hazard problem would not arise,’ says Wendy Carlin, Professor of Economics at University College London.

Observing the conduct, rigour and ultimately the creditworthiness of countless companies, as well as sovereign states, would be extremely useful, but it does seem too big an undertaking. Thankfully there are three prominent organisations set up to do just that. However, the records of Standard & Poors, Moodys and Fitch in the run-up to the crisis do not inspire confidence. Each of the big three credit ratings agencies maintained AAA ratings for various structured products even as the financial crisis loomed. Moody’s rated AIG as AAA until minutes before its collapse.

‘The unwillingness to allow big banks to fail meant that the public sector was shouldering a substantial amount of risk, whilst a rather small number of individuals were reaping extraordinary large rewards’

Roger McCormick
Visiting professor, London School of Economics and member of the IBA's Task Force on the Financial Crisis

Philip Wood QC, Special Global Counsel at Allen & Overy, describes the credit ratings agencies in the run-up to the crisis as guilty of ‘catastrophic misjudgements – but then so was everybody else.’ Besides, given that the ratings agencies are funded by the companies they rate, they seem ill suited to act as arbiters of a system aiming at morality. After the fact, of course, Moody’s showed great wisdom in hindsight. ‘The risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan,’ said Mark Zandi, co-founder of Moody’s ‘As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined.’  If credit ratings agencies can’t deal with the information asymmetry, perhaps financial institutions and sovereigns can police themselves. But again, track records provide scant optimism. Not only did Greece use off-book accounting techniques to mask the true levels of indebtedness it held, but Goldman Sachs accepted hundreds of millions in fees to help them to do it. For some, expecting financial actors to give primacy to moral concerns, and to look past what’s best for them, is a futile exercise. ‘As with most things with banks, it’s all about self interest, and this applies to governments too,’ says Stephen Powell, partner with Slaughter and May and Co-Chair of the IBA Banking Law Committee.

Instead, says Powell, ‘we think we need to step back and see what we want out of banks. We had, and in my view we will always have, a system where governments need to stand behind banks. Before 2007 we didn’t recognise that, and since then it’s become painfully obvious.’

The painful truth

What’s true for banks must surely be true for countries. If ‘too big to fail’ is now a fact of life, then surely sovereign states represent the biggest systemic risk of all. Several eurozone member states have accepted bailouts and imposed severe austerity as part of the bargain, but taxpayers in northern European countries perceived to be prudent, such as Germany and the Netherlands, have baulked at the transfer of money from their robust economies to countries they see as feckless and profligate.

Moral hazard explains the objection in part: if Greeks know that the Germans will bail them out, why should they start paying taxes, so the well-worn tabloid wisdom goes. There is a further moral objection. Within a currency union, transfers are expected: the South East of England knows that a substantial portion of its revenue will go to support the North East, which contributes comparatively less to the public purse. As citizens of a democracy, Britons are expected to accept that. However without political union across Europe, it’s much harder for citizens of one country to see the moral basis for another’s claim to their money. ‘Within national borders, bailing out entails transfers between citizens and there may be some political basis sustaining that,’ Carlin explains. ‘Across borders, the question is who is the European citizen/taxpayer? There seems much less political substance to that.’

Now Cyprus has become the latest to need financial life-support from above, and it seems the moral compass is shifting. The European taxpayer is no longer the only one on the hook: depositors with Laiki Bank and Bank of Cyprus face a serious haircut, and their money will only be protected up to €100,000. Above that figure, deposits will be used by the Cypriot government to contribute billions of its own to the bailout.

‘Big companies will always find a way of externalising the risk and it's difficult to find the individuals most responsible for externalising that risk’

Leif Wenar
Chair of Ethics Kings College of London

Commentators are hailing the deal as a template for future rescue packages: by forcing countries themselves to contribute, they are made, in part, to bear the costs of the risky behaviour that drove them to insolvency. Not for Cyprus a second or third bailout: after this, there’s no question of it returning to reckless conduct.

The real explanation may be less principled. To be blunt, perhaps it’s just that Cyprus is simply not too big to fail. The total bailout cost is a mere €10bn, and a substantial portion of the funds affected are held by Russian depositors. There are losses that European authorities are prepared to live with. However, Cyprus’ GDP is forecast to fall by up to 20 per cent over the next couple of years as its oversized banking sector shrinks back. Was it sensible to choose a nation so reliant on banking as the poster-child for moral hazard? Perhaps, in terms of political expedience – it gives Angela Merkel plenty of scope to talk tough on behalf of the Troika before the German elections later this year. For the people of Cyprus, however, a fifth of GDP is a high price to pay.

But pay somebody must. As Powell puts it, when such a fiscal shortfall appears, it’s like ‘one of the chairs has been removed from the party game, and it’s never going to come back’. The trick is to ensure that it’s bankers and not taxpayers left without a seat.

Reputational risk

One way to bring risk to bear on those who ran it is to make banks pay with their reputations. As Starbucks and Amazon can testify, if reputational damage becomes serious enough, it can force change at the highest levels. To this end, McCormick’s team at LSE has launched the Sustainable Finance Project, which is working to develop better indicators of a poor ethical culture, by compiling and totalling the levels of fines, settlements and comparable monetary indicators a given bank is paying out on an annual basis. These are not small amounts: HSBC paid $4.2bn in fines in 2012, while UBS paid out $1.5bn for manipulating the LIBOR inter-bank lending rate. With enough time and data, a league table could be produced, which compares financial institutions against each other. If a bank repeatedly finds itself coming bottom, the chair could be invited (or perhaps obliged) to explain why.

‘Comparable and accessible information, in a league table format, would add to the armoury of those, including the more responsible bankers, who wish to ensure that banks not only “restore public trust”, as they keep telling us they want to do,’ McCormick explains, ‘but also continue do what is necessary from now on to retain and deserve it’. If banks can’t be made to pay directly through their balance sheets, perhaps they can be made to pay with their reputations.

A step in the right direction, certainly, but bankers already have major reputational problems – it’s hard to see how public opinion of them could be lower, and yet record bonuses and salaries abound. Nevertheless, some still counsel against kneejerk, antagonistic sentiment towards the banking industry. The most important question when attempting to exit a crisis, Philip Wood says, is ‘how does a society look when it’s getting out of it? Do we react with vindictiveness and vengefulness? Or do we accept that there was gullibility and weakness of judgement, and try to improve that?’

Of course, a flood of regulation has attempted to rebalance the risk and information asymmetries embedded in the financial system. The 360,000-word Dodd-Frank Act has certainly divided opinion. Randall Guynn, Head of the Financial Institutions Group at Davis Polk & Wardwell and a member of the IBA’s Task Force on the Financial Crisis, said that ‘the regulatory reform in the US is so comprehensive that we have divided it up among ourselves just to survive’.

Lobbying, and consequent amendments, played a huge part in Dodd-Frank’s size and complexity. Indeed, pressure from lobbyists ensured that two years after the Act became law, only a third of its rules were in force. Connecticut Senator and act co-sponsor Christopher Dodd famously defended the legislation in the letters page of The Economist. Its repeal would lead us back to a world where ‘the public absorbs losses because of Wall Street’s risky behaviour, and regulators are left in the dark’.

However desirable it may be, most agree that the pursuit of a system that allocates risk fairly is doomed to failure. ‘Making a system in which everyone gets the harms and benefits from their own actions is never going to happen,’ says Wenar. Powell takes a similar stance:
‘By focusing on a point I don’t think we can ever change, I worry that we end up stifling banks and therefore business, which can’t be a good thing.’ Instead, Wenar argues, ‘the important thing is to look at the long-term consequences for individuals.’ A bottom-up redesign of the way the global financial system distributes risk may be too ambitious. However the outcomes for individual citizens – taxpayers – are much easier to observe, and can offer clues as to whether the system is laying disproportionate costs at their doors.

So are we doomed to repeat the mistakes of the past? If too big to fail persists, it seems that bailouts of some description will be inevitable, and it’s taxpayers who will find themselves footing the bill. Some promising proposals have been made: forcing banks to play with their own money by ringfencing retail operations, for example; or insisting that banks write ‘living wills’, so there’s a plan in place if they find themselves in crisis and they don’t have to turn to the central bank for a rescue. However, unless and until the financial system finds a way for its key actors to take responsibility for failure, it looks like moral hazard is here to stay – and the taxpayer is here to pay.


Recipient Amount Who Paid?
Northern Rock, 2007 $39.3bn (£26bn) Bank of England
AIG, 2008 $122bn US Treasury
Hypo Real Estate, 2008 $67.3bn Bundesbank and consortium of German banks
Royal Bank of Scotland, Lloyds $55.9bn UK Treasury
General Motors, 2009 $50bn UK Treasury
… and countries    
Greece (I), 2010 $142.3bn (€110bn) Bank, International Monetary
Ireland, 2010 $110bn (€85bn)

Troika (€67.5bn), Irish central reserves and pensions (€17.5bn)

Greece (II), 2011 $168bn (€130bn) Troika
Portugal, 2011 $101bn (€78bn) Troika
Spain’s nationalised banks, 2012 $51.7bn (€40bn) European Stability Mechanism (ESM)
Cyprus, 2013 $22.6bn (€17.5bn)

Troika (€10bn), the remainder coming from shareholder capital and uninsured deposits over €100,000 with the now defunct Laiki Bank


Tom Bangay is Managing Editor at the IBA and can be contacted at