Regulating financial markets and moral hazard: self-inflicted wounds
by George Hatjoullis
Financial markets are, in the mind of the man-in-the-street, simply a form of gambling. Unfortunately, this seems to be a view also held by politicians, the press and regulators. The thrust of all forces seems to be to reduce financial asset price volatility. The theory is that less volatility means less risk and less chance of financial crisis. Unfortunately it does not work like this and the relentless attempts to reduce asset price volatility is ultimately increasing the risk of crisis. Indeed the seeds of the 2007/2008 crisis were sown by the Federal Reserve in 2003 with the early attempt at forward guidance (recall the word ‘measured’). The forward guidance reduced expected interest rate volatility and encouraged an unrealistic view of the true system risk. The rest is now history.
Gambling creates risk in order for people to bet. The horses are made to run. Financial markets redistribute risk that exists and comes into existence through normal everyday activities. Everyone uses financial products; car insurance, house insurance, pension plans etc. If you did away with financial markets the risks would still be there. The function of financial markets is to slice these risks up into digestible portions and persuade someone to accept them, for a price. The insurance company uses actuarial models to determine the price. The company sells shares and distributes the risk widely and the takers of the risk share the losses and rewards. Small businesses issue debt and pay a risk premium to cover the risk of default. Banks lend money and diversify the risk of default across many small businesses. This is the basis of financial markets. Enter the concept of liquidity.
Efficient risk management requires that each player can adjust the risk position to suit circumstances. This is done via a market for risk. One can sell shares and bonds and this capacity enhances our willingness to invest in such assets. One can also sell and buy the volatility of the price of assets through options. One can sell the risk of default through various market products. The deeper and more liquid these markets, the lower the cost of transacting and the more ‘standardised’ is the price of the transaction. You do not want to have to call several brokers to get a price for your Royal Mail shares. You want to look at your online broking page and sell in the knowledge that it would have been the same price whomsoever you sold through. Of course, regulation has a big role to play in the trust that individuals have for markets. However, if the regulation enforces such trust in such a way that it kills the liquidity and depth of the market, it is killing goose.
How does liquidity and depth emerge in any financial market? You will not like the answer. Liquidity is provided by the informed speculator ( I told you that you would not like the answer). A speculator is anyone that commits capital to buying and selling an asset. The existence of a lot of speculators means there is always someone to sell to and buy from, at a price. You may not like the price but it is there. Without speculators you are reliant on brokers. The broker matches buyers and sellers and takes a commission. There may not be someone wishing to buy as much as you wish to sell and the market liquidity can vary. The liquidity is better if there is someone who is making a living out of buying and selling.
Investment bankers might argue that my definition of a speculator is a market-maker. True. However, the market maker within an investment bank is supposed to keep risk exposure to a minimum and make most of the profit via a spread between the bid and the offer price. At any point in time there is always a position mismatch and an implicit view on direction. The mismatch may be ‘hedged’ via a highly correlated asset but that is just adding another risk; basis risk. The market-maker is a low risk speculator but a speculator none the less. Other speculators are more transparent (hedge funds). They look to make money by guessing the direction of the price move. In the process they create market liquidity for those that need the market to facilitate their normal business transactions. Problems can arise when the tail starts wagging the dog.
One great speculator (and economist) put it rather well in The General Theory of Employment Interest and Money;
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done… ” J M Keynes.
One of the many roles of the regulator is to avoid speculation becoming excessive and distorting the underlying economic activity that the financial markets exist to facilitate. The regular recurrence of financial crises suggests that the regulator has not found this easy.
One important factor in avoiding excessive speculation is to eliminate moral hazard. If the speculator believes she/he has a win-win bet then the bet size will become large. If the speculator believes that someone is limiting downside losses then the bet size will become commensurate. Ironically, the state frequently intervenes in financial markets and creates these moral hazards. Central banks have done so, for example, through forward guidance. Governments have done so via mortgage insurance, help-to-buy, funding-for-lending etc. All such interventions create a little moral hazard. They distort the perception of risk and encourage unrealistic bet sizes. Stop doing it!
Speculators are very rational agents. They are typically very well-informed. If they see a two-way risk and the downside could take them out of the game, they reduce positions. Moreover, in a world of confusion there will be as many one way as the other. It is only when perceived certainty is introduced, e.g. by the state, that positions become large and one way. It is then that speculation becomes excessive and the tail starts to wag the dog. Removing market uncertainty will lead to the next crisis.