Our weekly explainer on economics using lessons from popular culture. In Installment 19, Gabbar Singh teaches us about Moral Hazard.
Countless movie-goers have watched the entry scene of Amjad Khan (aka Gabbar Singh) in Sholay with rapt attention. Even today, going by the number of spoofs and parodies available on the internet, it remains incredibly popular. What if I tell you that this scene also teaches a lot about economic theory in general and financial crises in particular?
The invisible thread that connects the iconic scene with financial crises is Moral Hazard. Moral Hazard is a central idea in information economics; as Joseph Stiglitz once said, moral hazards are everywhere. Alas, the term is a bit of misnomer: It is neither about morality, nor about hazards.
Essentially, Moral Hazard is about the age-old problem of separating effort from luck. Ecclesiastes, part of the Hebrew bible, noted the problem some two thousand years ago in a beautiful expression:
I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favor to men of skill; but time and chance happeneth to them all.
If the race is not to the ‘swift’ and there is an element of ‘chance’ in every outcome, some economic transactions become extremely hard to execute. Sholay provides one such example. In the movie, Gabbar Singh is the principal and Kaliya (Viju Khote) is the agent. Gabbar is in the business of robbery and allied activities (one assumes) such as extortion and levy-collection. Like every savvy businessman, Gabbar cares deeply about his reputation. He beams with pride while declaring that government has announced a reward of fifty thousand rupees (purey pacchaas hazaar) on his head. He is pleased by the fact that in an area covering fifty kilometers, his name is sufficient to scare off little children.
Such a formidable reputation can not be built individually. It requires a team effort. That is where Moral Hazard rears its head. The first element of moral hazard is the asymmetry of cost and benefits. While much of the benefit of reputation-building goes to the principal (Gabbar Singh), the costs are borne by the foot-soldiers like Kaliya. He must pick up dangerous fights every time Gabbar’s writ is challenged.
The second element of moral hazard is the obfuscation of effort and chance. Not every fight of Kaliya can be personally observed by Gabbar. Only the outcome of his effort can be monitored. (For example, whether he has brought enough booty or not.) Outcomes are a product both of the agent’s effort and chance. As such, the best course of action for agent (Kaliya) is to make no effort, just run away and report that he lost the fight due to bad luck (or some other factor beyond his control). That is precisely the course of action followed by him in the movie.
How does one deal with Moral Hazard? There are many approaches, but one of them was proposed by James Mirrlees in his seminal paper on moral hazard (it was published in 1975; coincidentally, Sholay was released in the same year). Mirrlees solution is to inflict disproportionate punishment for adverse outcomes, irrespective of the agent’s level of effort. Nobel laureate Kenneth Arrow once called such a punishment ‘admiral shot for cowardice’. Of course, Gabbar Singh, being game theorist par excellence, knows this solution. He delivers his ‘admiral shot’ with characteristic panache and drama: Jo dar gaya samjho mar gaya.
Back to the financial economics. Why do banks fail? The textbook answer is that bank failure is due to asset-liability mismatch. Banks have short-term, liquid liabilities; they have long-term and illiquid assets. A depositor can approach his bank and withdraw his money at a short notice; a bank cannot recover its loans that easily. When a sufficient number of depositors withdraw their money, a bank must close down. This answer is formally correct, but still unsatisfactory.
Why do we have such a fragile capital structure in the first place? Why not bifurcate the banks into payments banks (which borrow short-term and invest in safe and liquid securities such as treasury bills) and investment banks (which lend to risky and long-term projects but borrow by issuing long term bonds)? Such a financial structure will be very stable; it will rarely run into financial crisis.
There are ways to drastically reduce, even eliminate, the possibility of bank runs. Still, banks with a vulnerable capital structure have been around for at least 1000 years, and banking crises have been a recurring phenomenon throughout history. Why?
Shurojit Chatterji and Sayantan Ghoshal provide one answer to this puzzle (Douglas Diamond and Raghuram Rajan give a similar answer that is slightly different in details). Stripped of mathematics, Chatterji and Ghoshal’s argument is a straightforward adaptation of Sholay’s drama.
Depositors engage bankers to manage investments on their behalf. Investment requires diligence and skill. The benefits of efforts go to depositors while the cost are borne by the bankers. Second, bankers’ actions are difficult to monitor. Projects may go sour either due to poor investment strategy or due to external factors such as economic slowdown, bad policies and so on.
Both elements of moral hazard are present here. What if the banks do not apply due diligence and then just blame economic climate and international demand conditions for bad outcomes? Worse still, what if they cut a sweetheart deal with borrowers?
For the entire system to be sustainable, there must be the fear of an ‘admiral shot’ somewhere. There must be the possibility of strict punishment in certain contingencies. A fragile capital structure provides precisely such a punishment instrument. The fear of a run on their deposits keeps banks on their toes. This is the reason why bank crisis has been a recurring theme throughout the history, despite the enormous pain it evidently inflicts.
If for some reason banks are fully insured against the possibility of runs, the problem of Moral Hazard gets accentuated. To some extent, this is the situation in India. Given the dominance of public sector banks in India, everyone expects bailouts.
It is not a coincidence that we have had an NPA crisis in the nineties and again in this decade. In a Faustian bargain, we have traded financial stability for an endemic and festering Moral-Hazard problem (which manifests itself in the form of NPAs).
Both Moral Hazard and financial economics are huge subjects, and one movie sequence (and one explanatory article) can only be a ‘trailer’. Still, as Winston Churchill once said: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”