Deutsche Bundesbank's Weber: Lessons in Moral Hazard and Market Discipline

From a speech by Professor Axel A. Weber (pdf file), President of the Deutsche Bundesbank: Moral Hazard, Market Discipline and Self-Regulation – What Have We Learned?

Securitisation – The securitisation market has played a critical role in the financial crisis. Prior to the crisis, a lack of transparency in this market aggravated wrong incentives in the originate-to-distribute business model. As credit risk was well hidden in highly structured products, it was easily transferred to other market participants. This in turn increased the incentive to originate credit risk. Consequently, credit standards deteriorated, contributing to overheating phenomena such as those seen on the American housing and loan market. The fact that market participants often relied solely on credit ratings and that these ratings did not always capture the credit risk adequately aggravated the situation. Once the crisis had begun, the lack of information on the risk profile and profitability of the highly structured products increased the distrust among market participants, thus aggravating the financial turmoil.
In order to revive this largely beneficial market, a necessary condition is to restore confidence among market participants by enhancing market transparency. The transparency and quality of credit ratings is definitely one starting point in this process. I would like to stress that credit ratings should never replace the investor’s responsibility to evaluate the risk of a financial product. But transparency in the rating process – especially in the segment of often opaque and multilayered structured credit – is a prerequisite for investors to behave responsibly. Only a sufficiently transparent rating process that represents negative incentive effects for rating agencies will enable the investors to make informed judgements about the product characteristics as well as the quality of the rating process itself. It should be mentioned in this context that initiatives led by IOSCO, the international organisation of securities supervisors, point in the right direction. In the course of this month, IOSCO is expected to report on improvements of transparency provisions in individual Codes of Conducts of credit rating agencies.
Another issue at stake is the lack of market standards in the securitisation market. Market participants must have easy access – for example, via a central data portal – to information on transactions in the securitisation market, the underlying asset portfolio and further transformation of the securitisation. The information provided should include, among other things, details about any retention of a share of securitised products on the balance sheet of the originator. This would reveal the originator’s incentive structure and thus unveil possible moral hazard problems. In addition, there is strong need for international harmonisation of common terminology as well as disclosure requirements.

Self-regulation – In general, there are two possible paths that can be followed with regard to market regulation. Regulation can either be imposed on the relevant institutions in the financial sector by regulator agencies or the institutions themselves can willingly agree on regulation. In the second case, we are talking about self-regulation. Self-regulation has the advantage that market participants tend to identify with the self-imposed rules, which should result in a higher acceptance of the regulation. Moreover, market participants might have better knowledge of the market, leading to more flexible and less costly solutions. However, as the current financial crisis underscores, self-regulation bears the risk that regulation will remain too lax or that the market participants will not comply with the self-imposed rules. This is an example of the well-known problem of collective action. Consequently, it has to be decided carefully whether self-regulation can be sufficient for a well-defined field of finance.

Market discipline – Market discipline describes a mechanism in which market participants have an incentive to monitor the risk behavour of counterparties with the aim of readjusting their investment decisions accordingly. In the aforementioned case of securitisation, the risk-taker might be penalized by its share holders and other counterparties if a lack of monitoring impairs his ability to assess credit risk properly. Hence, market discipline has the potential to correct inefficiencies arising from credit risk transfer. However, there is a very important prerequisite for market discipline: transparency. Only if the market participants recognize that a moral hazard problem is arising will they have the option of adjusting their investment decisions accordingly. While transparency is a necessary condition for market discipline, it is by no means sufficient on its own. In addition, market participants must have the ability and incentive to use the information. Especially in times of economic expansion, the incentive to acquire and use the information might be low as the general default risk remains relatively muted as long as the upward trend continues. A restraining effect via market discipline is rather unlikely in this case. Therefore, transparency and market discipline can sustain financial stability but they should not replace market regulation. In addition, market regulation itself is necessary for enhancing transparency.

Moral hazard – In order to illustrate the concept of moral hazard, I would like to look at the process of credit risk transfer in the form of securitisation, which played a key role in the events leading to the current financial crisis. Principally, credit risk transfer is a very beneficial means of allocating risk in the financial market as it disconnects the originator of a risky asset from the ultimate risk-taker. The downside of this separation is, however, that once the credit risk is forwarded there is no incentive for the originator to monitor the debtor. This is what we call moral hazard and what has ultimately resulted in an erosion of credit standards not only in US subprime but also in other credit market segments. In general, the ultimate risk-taker does not have the necessary information to monitor the debtor and the transfer process unnecessarily complicates the default risk assessment of the securitised assets.

Comments

[MartynStrong:]

Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable. By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day? So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days. The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one's investments every 7 days (based on the specs you give the agent). A system like this will make the financial markets work as smoothly as the local fruit market.

Feb 18 12:35 AM

[blasted:]

Deutsche bank has the most forclosures of any bank in the Fort Wayne IN market and the loans are mostly in the very worst neighborhoods on houses that need to be torn down. I am amazed I haven't heard more about it. Now I know it was all originate to distrubite. They would be bankrupt if they weren't just acting as the trustee for who ever really owns that worthless paper.

Feb 18 05:25 PM