One of the more remarkable moments in yesterday’s Financial Crisis Inquiry Commission came when Jamie Dimon, the C.E.O. of J.P. Morgan, said that his bank had never tested its portfolio against the possibility that housing prices would fall. This was especially telling when you consider that J.P. Morgan was, of all the big banks, the one that was least enmeshed in the subprime market, which suggests that if it didn’t contemplate the chance that the housing market would crash, it’s unlikely any of the other banks did, either. Over at Free Exchange, Ryan Avent mused on what this means for the oft-heard argument that one of the engines of the financial crisis was moral hazard: big banks’ assumption that if things went horribly wrong, they would end up bailed out. He writes, “If the financial sector couldn’t conceive of a world in which house prices fell, they might also have struggled to conceive of a world in which the financial sector was troubled enough that even relatively small banks would be shielded from collapse, as was the case after Lehman’s failure.”
Ryan doesn’t quite seem happy with the conclusion that moral hazard didn’t have much to do with this particular crisis, but I think it’s the right one. As I argued last year, when it comes to institutions, the moral hazard explanation for what went wrong doesn’t really hold much water. In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.
In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies. The crisis, in that sense, was caused less by the fact that the banks were too big to fail than it was by the fact that they never seriously considered the possibility that they might fail.
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