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1. To the Point
Discussion on the economy, by the Chief Economist February 26, 2010
Cecilia Hermansson
Chief Economist
Economic Research Department
+46-8-5859 1588
cecilia.hermansson@swedbank.se
No. 2
2010 02 26
Don’t underestimate the importance of
moral hazard
The global financial crisis and Greek tragedy have something in
common: the faulty estimation of risk. The reasons why investors and
creditors calculate risks badly are many, but one of them deserves
more focus, viz., the moral hazard phenomenon.
This version of the To the Point analyses the importance of moral
hazard for actions taken on financial markets, focusing on the crises
on the private financial markets and with regard to sovereign debt.
There are some common aspects, but also some major differences.
The discussion on moral hazard revolves around timing. As the crisis
unfolded, policy action was needed in order to avoid a much worse
situation in the financial sector and the real economy. The boat was
sinking, and there was a need to get to the shore. On the other hand, as
the financial crisis has abated there is a need to discuss more in depth
the impact of moral hazard, and possibly there is something to be
learnt also for the European situation, although there, crisis
management must still get first in line.
What is moral hazard?
Moral hazard appears when an actor who is insulated from risk
behaves differently than if this person or institution were fully
exposed to risk. In insurance markets, moral hazard occurs when the
behavior of the insured party changes in a way that raises costs for the
insurer. For example, a family with insurance against flood damage
may have an incentive to locate their house closer to a river than a
family that would bear the entire cost of a flood.
Financial bailouts by governments and central banks can encourage
risky behavior in the future if those who take the risks believe they
will not have to carry the whole burden if losses occur. Often, one
party has more information than the other, and, with the information
asymmetry, the party with less information ends up taking
responsibility for the consequences of these actions. Taxpayers have
thus often had to finance the losses occurring from financial crises.
Moral hazard can occur with banks and other financial agents acting
on behalf of another party, i.e. the principal with less information, but
also with borrowers who do not act prudently. There are
countervailing pressures on banks that limit incentives for risk taking.
Regulation and supervision are important pressures, but, if these fail,
the risks of moral hazard increase.

2. To the Point (continued)
February 26, 2010
2
More important, the fact that an institution can fail imposes a large
cost on bank owners and managers, who then lose their jobs. In 2007,
the investment bank Bear Stearns had traded for as much as 172
dollars per share, but when it was bought by J.P. Morgan Chase, the
price fell to 2 dollars per share. If financial institutions are protected
by governments, shareholders are not protected, but creditors are. So
the focus should be on creditors and banks that take on excessive risk,
thereby reducing discipline because they believe in government
protection. In a vicious circle, high-risk behavior increases the chance
of bank failure and bailouts by governments.
Those who find the argument of moral hazard farfetched should adopt
a long-term approach. Deregulation of the financial sector in the
1980s, especially in the US, with the existing inadequate supervision,
created an environment where risks were taken excessively, and
where resources were allocated incorrectly, causing costs for society.
The financial sector grew as a result, and its profits as a share of the
total profits increased from some 20% at the beginning of the 1980s
to almost 50% in 2007, before the onset of the most recent financial
crisis.
The US financial crisis
Gary Stern and Ron Feldman (both from Federal Reserve Bank of
Minneapolis) wrote a book, “Too big to fail – the hazard of bailouts,”
in 2004. They argued that the too-big-to-fail (TBTF) problem was
getting worse, and needed immediate attention. As the financial crisis
started in the US in 2007, there was a massive across-the-board
expansion of financial institutions’ safety nets. The TBTF problem
has become worse since then as the largest and the most
interconnected firms have become even larger and more
interconnected due to the support they have received. Unless the
TBTF problem is reduced, there is a risk of a new financial crisis
sooner rather than later.
Protection of uninsured creditors of banks is the factor that underlies
the concept of TBTF. Between 1979 and 1989, some 1,100
commercial banks failed, but 99.7% of all deposit liabilities were
fully protected by the discretionary actions of US policymakers. Size
is also important, as special protection is provided for creditors to big
or interconnected banks. Over the years, creditors have believed the
banks they are funding will be bailed out, and this belief has
influenced the risks they have taken.
When Bear Stearns was protected by J.P. Morgan Chase’s stepping in
with the support of US policymakers, the financial markets were
relieved, because the environment remained unchanged. When
Lehman Brothers filed for chapter 11, however, the shock was
immense, as financial markets had started to believe in eternal
bailouts. Some time afterwards, however, policymakers had to
reassure the financial markets that the pre-Lehman Brothers
environment would be restored, so that confidence could return.
Small and unimportant regional banks tasked with lending to SMEs
and households have thus been allowed to fail, while the big ones
have become even bigger.

3. To the Point (continued)
February 26, 2010
3
Chart 1: Public deficits as a share of
GDP, for selected OECD countries (%)
-16.0 -14.0 -12.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0
Ireland
USA
UK
Greece
Spain
Japan
France
Portugal
Italy
Germany
Denmark
Finland
Sweden
Source: European Commission
Chart 2: 10 year Government bond
interest rate spreads to Germany for
selected Euro countries
Source: Reuters EcoWin
jan
07
maj sep jan
08
maj sep jan
09
maj sep jan
10
Percent
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Greece
Italy
Belgium
France
Spain
Portugal
Sweden
Source: Reuters/Ecowin
Also, the borrower has been bailed out through special measures to
reduce mortgage interest rates and to provide direct support to
households in need. Monetary policy has also played a role over
many years, as the so-called Greenspan put created an environment in
which interest rates were lowered as asset markets fell but were not
similarly raised as asset markets rose. This asymmetric monetary
policy has come to an end, though, as the policy interest rate has
already hit bottom. Mortgage loan interest rates could go lower, but
not by much.
As the crisis has abated, the concern for moral hazard is coming back
into focus in the US. Reenactment of the old Glass-Steagall act
separating investment and commercial banking has been proposed.
There are those who find the elimination of the Glass-Steagall act in
1999 a trigger for the buildup of TBTF institutions. Balance sheets
can always be manipulated; thus the issue of bailouts may be just as
important as the split between investment and commercial banking.
Professor of Economics Carmen Reinhart points to four options for
solving the TBTF problem: (1) no one gets bailed out (theoretically
pure, but less credible as bailouts have been common historically and
contagion can be costly) (2) everyone gets bailed out and regulations
are not established, i.e., the basis for a new crisis; (3) the TBTF
doctrine is applied in radical steps and institutions are dismembered;
and (4) credit growth and leveraging are closely monitored, and
institutions are regulated according to their indebtedness. She finds
that, although risk is difficult to measure, debt levels can be
monitored. The only way to solve the problem of moral hazard is to
create an environment in which bailouts are not expected
automatically. To get there may cause more turbulence on financial
markets, and thus we have not yet solved the financial crisis.
The European sovereign debt crisis
There are some similarities between the US financial markets crisis
and the European (Greek) sovereign debt crisis. After 2001, when
Greece adopted the euro and became a member of the common
currency, financial markets saw the risk of giving credits to Greece
fall gradually: Long-term (10-year) government bonds were just 1
percentage point above the equivalent German rate in 2007.
During 2008 and 2009, this interest rate spread widened when the
extent of the Greek fiscal situation became more clear, and when it
was announced that the ECB stimulus measures would be withdrawn,
thus reducing the possibilities of using less creditworthy Greek bonds
as collateral for borrowing cheaply at the central bank. Financial
markets have thus repriced the risk. Greece is still part of the currency
union, but lending to Greece is no longer seen as a low-risk activity.
The moral hazard problem may be hard to see here, as it is unlikely
that governments would risk the future of a country that is counting
on being helped out by other governments. The pain of having a
financial and fiscal crisis in a country is severe. On the other hand,
countries not having experienced these crises (unlike Japan, the
Nordics, and East Asian countries) may underestimate this pain, and
it is not until they have experienced it for themselves that

4. To the Point (continued)
February 26, 2010
4
Chart 3: Real effective exchange rates for
selected countries
Source: Reuters EcoWin
97 98 99 00 01 02 03 04 05 06 07 08 09
Index100=1997
90
95
100
105
110
115
120
Spain
Portugal
Greece
Italy
Germany
Source: BIS
Economic Research Department
SE-105 34 Stockholm, Sweden
Telephone +46-8-5859 1000
ek.sekr@swedbank.com
www.swedbank.com
Legally responsible publishers
Cecilia Hermansson
+46-8-5859 1588
cautiousness rise and fiscal discipline increases. Other aspects that
possibly better explain the lack of discipline in the case of Greece are
the short-sighted political process of attracting votes, corruption and
tax evasion, and the general distrust of the political establishment.
The Greek government found less transparent ways of entering the
EMU, had a free lunch for a few years as creditors did not calculate
risks properly, and has not used the resources thus obtained
responsibly. The budget deficit has risen to a level that would have
been high even before the crisis, public debt has increased to more
than 100% of GDP, and competitiveness has decreased since entrance
into the EMU. The real effective exchange rate has appreciated by
some 20% since joining the euro, and the current account deficit was
already as high as 15% of GDP in 2007, before the sovereign crisis
escalated.
Just as in the case of the US financial crisis, it is better in the case of
Greece to focus on creditors rather than governments or shareholders.
The European banks lending to Greece have counted on a bailout of
the Greek government, despite the explicit prohibition of such an
action in paragraphs 123 and 125 of the Lisbon Agreement. To count
on paragraph 122 is a bit optimistic as the Greek fiscal mess is not
exogenous and therefore cannot be regarded as an act of God, like a
tsunami or an earthquake. Germany has strong objections to giving
any support to Greece, pointing to the Stability and Growth Pact, to
which not even the big economies have adhered. The euro zone still
has to come up with ways to reduce the risk of contagion to Spain and
Portugal, and perhaps also to Italy, Belgium, and Ireland. Bailing out
is not the first option, and to put conditions on possible future support
is the best message that can be given to financial markets at this stage.
I believe that, just as in the case of the US financial crisis, when the
boat is still leaking, ways have to be found to bring the boat to the
shore. There are too many risks connected with not doing anything at
all. The best solution would be for Greece to make it on its own. But
if not, there have to be ways to mitigate the crisis either with help
from the EU/euro zone alone, or in combination with the IMF.
When the crisis has been solved, at least as well as possible, the focus
must again be on moral hazard. For Europe, it is important to find the
right institutional framework that works both during relatively
tranquil times and during times of turbulence. During the tranquil
times, risks may be taken excessively, but with the right incentive
structure, there would be less risk of creating bubbles or misallocating
funds, whether on private markets or in the public sector. Moral
hazard may not be the most important factor explaining the Greek
crisis, but for the future of the euro this problem deserves attention.
Cecilia Hermansson
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