Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility

There is an increasing worldwide focus on trying to end the problem of “too big to fail” (“TBTF”). Regulators are concerned that systemically important financial firms might engage in excessive risk-taking because they would profit from a success and be bailed out by the government in case of a failure. This is primarily a problem of moral hazard, that persons protected from the negative consequences of their risky actions will be more tempted to take more risks.

My new article, available here, argues that, contrary to accepted regulatory wisdom, the problem is exaggerated. The central evil of TBTF is based on the assumption that the expectation of a bailout will cause systemically important firms to engage in morally hazardous risk-taking. The article contends that excessive corporate risk-taking is not caused by this bailout-associated moral hazard. Rather, such risk-taking is more likely caused by other factors, including the governance requirement that corporate managers—including managers of systemically important firms—view the consequences of their firm’s actions only from the standpoint of the firm and its investors, ignoring systemic externalities that can harm the public. As a result, regulating excessive risk-taking by regulating TBTF can be inefficient, ineffective, and sometimes even dangerous.

TBTF Does Not Cause Morally Hazardous Behavior

There is no evidence, much less proof, that TBTF causes firms to engage in morally hazardous behavior.  Most studies discussing such behavior merely assume it, without actually offering evidence. Other studies conflate correlation and causation, assuming that, if many systemically important firms engage in risky behavior, that behavior was predicated on bailout expectations.

The economic studies purporting to “prove” that TBTF causes firms to engage in morally hazardous behavior merely show that systemically important firms can borrow at lower cost, presumably because investors believe they will be bailed out. But that does not say anything about whether those firms in fact engage in that behavior. There are many other reasons why systemically important firms, which generally are large, can borrow at lower cost than smaller firms, including that large firms generally have better access to debt markets and larger dividend pay-out ratios, and their credit is less vulnerable to market disruption. Nor do those studies attempt to examine whether systemically important firms can borrow at lower cost than non-systemically-important large firms.

The idea that TBTF causes systemically important firms to engage in morally hazardous behavior is also antithetical to managerial incentives. Managers who cause their firms to engage in excessive risk-taking, in the expectation the firm will be bailed out by the government, are taking serious personal risks. If the government fails to bail out the firm, those managers are almost certain to lose their jobs. Even if there is a bailout, it may well be conditioned on those managers resigning or otherwise giving recompense. In either case, the ensuing reputational damage may well permanently end a manager’s financial career.

So why is there such a widespread belief that systemically important firms engage in morally hazardous behavior? One reason, perhaps, is that moral hazard is a common explanation for any excessive risk-taking, including excessive risk-taking by firms. Attributing excessive corporate risk-taking to moral hazard also accords with the human inclination, inflamed by politicians and the media, to view harm as being caused by wrongdoers. It also goes without saying that “too big to fail” is a great sound-bite.

Other Factors Cause Systemically Important Firms to Engage in Excessive Risk-Taking

If moral hazard does not cause systemically important firms to take excessive risks, then why do they sometimes engage in that risk-taking? One explanation is that managers, who exercise judgment when engaging their firms in risk-taking, do not regard risk-taking that is excessive from a public perspective as necessarily excessive from the perspective of the firm and its investors.

Systemically important firms can engage in risk-taking ventures that have a positive expected value to their investors but a negative expected value to the public. That’s because much of the systemic harm from such a firm’s failure would be externalized onto other market participants as well as onto the public, including ordinary citizens affected by an economic collapse. The misalignment is compounded because corporate governance law requires managers to view the consequences of their firm’s actions, and thus to view the expected value of corporate risk-taking, only from the standpoint of the firm and its investors. That perspective ignores public externalities caused by the actions.

In general, that makes sense. Myriad externalities result from corporate risk-taking, and regulation cannot feasibly take them all into account. But risk-taking that causes the failure of a systemically important firm could trigger a domino-like collapse of other firms or markets, causing systemic externalities that damage the economy and harm the public. Corporate governance law should try to take that risk-taking into account.

TBTF-Related Regulation of Excessive Risk-Taking May Be Misguided

If the assumption that moral hazard causes systemically important firms to engage in excessive risk-taking is incorrect, then regulation starting from that assumption is unlikely to control that risk-taking and could even be harmful.

Consider, for example, the highly politicized regulatory focus on breaking up systemically important firms and limiting their size so they are no longer systemically important. If moral hazard does not cause systemically important firms to engage in excessively risky behavior, then this approach would merely reduce the number of systemically important firms that can engage in such behavior. Limiting firm size can be harmful, however, undermining the economies of scale and scope that firms need to compete successfully in an increasingly globalized and interconnected world.

Another TBTF-related approach to regulating excessive risk-taking is to impose higher capital and other requirements on systemically important firms. But even regulators are uncertain whether higher capital requirements will discourage excessive risk-taking. Furthermore, unintentionally excessive capital requirements might create credit shortfalls, cut into global economic output, and reduce jobs.

Excessive Risk-Taking Should Be More Directly Regulated

If systemically important firms are more likely to engage in excessive risk-taking because much of the systemic harm from their failure would be externalized, the more direct way to regulate that risk-taking should be to correct the misalignment between public and private interests. I have elsewhere argued that that can best be done by regulating the corporate governance of systemically important firms. See Misalignment: Corporate Risk-Taking and Public Duty, 92 Notre Dame L. Rev. 1 (forthcoming Nov. 2016), available here. Managers of systemically important firms should have a duty to society not to engage their firms in excessive risk-taking that leads to systemic externalities. So long as it does not unduly weaken wealth-producing capacity, regulating governance in this way would help to align private and public interests. My Misalignment article analyzes in detail how to design such a duty that does not unduly weaken wealth-producing capacity.

This approach is different from the regulatory responses to the financial crisis that attempt to mitigate excessive risk-taking by aligning managerial and investor interests. Those types of responses are insufficient: Even if managerial and investor interests to engage in risk-taking could be perfectly aligned, that would not necessarily control risk-taking that causes systemic externalities. Those externalities result from a misalignment of interests between the firm, its investors, and its managers on the one hand, and the public on the other hand.

Even if regulating the governance of systemically important firms could directly control their excessive risk-taking, such a firm could fail because that control is imperfect or for exogenous reasons. Government central banks traditionally are tasked with helping to bail out critical banks to prevent them from defaulting. They appear to perform this task well, subject only to concerns over whether that imposes a bailout cost on taxpayers and whether it fosters moral hazard. These concerns could be addressed in various ways, including by taxing systemically important firms to create a (at least partly) privatized bailout fund. In the United States, there are analogous precedents for requiring the private sector to contribute funds to help internalize externalities.

Privatizing bailout costs raises certain practical concerns. For example, we have insufficient experience to precisely determine these costs, and thus to assess the exact amount each systemically important firm should be taxed. If taxes are too low, taxpayer funding may be needed to cover shortfalls. If taxes are too high, that could decrease efficiency by decreasing the amount of capital that financial firms can use to invest. The bailout fund is contemplated merely as a fallback, however, to the primary remedy of imposing a public governance duty to reduce excessive risk-taking; if that remedy works, relatively few systemically important firms would need a bailout. My article’s proposal for a bailout fund should therefore be much more practical than previously advanced conceptions for bailout funds as a primary remedy.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University School of Law and Senior Fellow at the Centre for International Governance Innovation. It is based on his recent article, “Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility,” available here.