This article argues that the crisis of 2007–2008 happened because of an explosive combination of agency problems, moral hazard, and “scientism”—the illusion that ostensibly scientific techniques would manage risks and predict rare events in spite of the stark empirical and theoretical realities that suggested otherwise. The authors analyze the varied behaviors, ideas and effects that in combination created a financial meltdown, and discuss the players responsible for the consequences. In formulating a set of expectations for future financial management, they suggest that financial agents need more “skin in the game” to prevent irresponsible risk-taking from continuing.
[N]obody should be in a position to have the upside without sharing the downside, particularly when others may be harmed. While this principle seems simple, we have moved away from it in the finance world, particularly when it comes to financial organizations that have been deemed “too big to fail.”
The best risk-management rule was formulated nearly 4,000 years ago. Hammurabi’s code specifies:
“If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.”Clearly, the Babylonians understood that the builder will always know
more about the risks than the client, and can hide fragilities and improve
his profitability by cutting corners—in, say, the foundation. The builder can
also fool the inspector (or the regulator). The person hiding risk has a large
informational advantage over the one looking for it....
The Hammurabi rule marks the separation between an agent’s interests and those of the client, or principal, she is supposed to represent. This is called the agency problem in the social sciences. Often closely associated is the problem of moral hazard, wherein an actor has incentive to behave in an economically or socially suboptimal manner (e.g. overly risky) because she does not bear all of the actual and/or potential costs of her action. In banking, these two are combined most acutely in the case of large institutions that may be deemed “too big to fail,” as increased risk taking (moral hazard) may lead to greater interim compensation to management (agent) at the expense of junior claimants such as shareholders and guarantors (taxpayers, etc.) (principals). The Hammurabi rule solves the joint agency and moral hazard problem by ensuring that the agent has sufficient non-diversifiable risk to incent the agent to act in the joint interest of the agent and the principal.
Read the full paper here [PDF].