Immoral Hazard

Out along the edges
Always where I burn to be
The further on the edge
The hotter the intensity
--Kenny Loggins

Warren Buffett proposes that the 'solution' to excessive risk taking by bank execs is to excessively penalize these execs in the event of big losses. Shareholders didn't cause the recent meldowns, he suggests, but they have bourne the brunt of the losses.

Shareholders had no role in the meltdowns? They bid up share prices of highly leveraged firms, and voted in top execs, the boards, and lavish pay/incentive structures.

The way markets are supposed to work is that firms that make bad decisions get penalized. If the decisions are poor enough, then the firm goes away and someone else takes control of the resources who looks to be able to do a better job.

What role do shareholders have good decision-making? They can look at the level of risk on a firm's balance sheet and don't buy (or sell) shares of firms that have excessive leverage. Extreme leverage was visible to anyone willing to look prior to the meltdown. The argument can easily be made that shareholders, like managers, were willing making leveraged bets on a risky strategy that went awry.

Shareholders can also walk away from firms that have undesirable incentive structures.

Warren Buffett seeks to bake additional moral hazard into a system that already has millions of players thinking that someone has their back.

In properly functioning markets, shareholder they take responsibility for their role and bear the consequences their decisions.