Moral Hazard and Equity Finance: Why Policy has been Sub-optimal since the Global Financial Crisis

Whereas this Chapter was written before the coronavirus pandemic struck, I see no reason to amend or alter any of its contents and arguments. Its thesis is that macroeconomic policy remained sub-optimal in the years between the Great Financial Crisis (GFC) and the onset of Covid-19. The main reason why this has been so is that there has been a generalised failure to appreciate the moral hazard that was introduced into the modern capitalist economy by the legal institution of limited liability for all equity holders. The incentive structure induced by limited liability has led corporate managers, notably bank managers, to seek excessive risk and leverage in the pursuit of return on equity (RoE), egged on by shareholders. There has been a tendency to accuse bankers of moral failings; whereas there is little evidence that bankers are significantly different from other humans, except, perhaps, in having better numerical and computational skills. An associated failing has been to anthropomorphise banks, and treat them as if they were human beings, whereas nonsentient institutions banks have no emotions and cannot make decisions; only bankers can do that. While the policy measures of requiring banks, especially larger banks (SIFIs), to hold significantly more equity capital, has been correct and helpful, the failure to deal with the underlying moral hazard has meant that bankers still have a strong incentive, in pursuit of RoE, to avoid or evade, and manipulate, the regulations, rather than internalise the optimal level of social risk taking. Section II gives a fuller analysis of the implications of the moral hazard inherent in limited liability for all equity shareholders.