Primers

Primers

 
 
Posts tagged Leverage
A Primer on Private Sector Balance Sheets

Double-entry bookkeeping is an extremely powerful concept. Dating at least from the 13th century (or possibly much earlier), it is the idea that any increase or decrease on one side of an entity’s balance sheet has an equal and opposite impact on the other side of the balance sheet. Put differently, whenever an asset increases, either another asset must decrease, or the sum of liabilities plus net worth must increase by the same amount.

In this post, we provide a primer on the nature and usefulness of private sector balance sheets: those of households, nonfinancial firms, and financial intermediaries. As we will see, a balance sheet provides extremely important and useful information. First, it gives us a measure of net worth that determines whether an entity is solvent and quantifies how far it is from bankruptcy. This tells us whether an indebted firm or household is likely to default on its obligations. Second, the structure of assets and liabilities helps us to assess an entity’s ability to meet a lender’s immediate demand for the return of funds. For example, how resilient is a bank to deposit withdrawals?

After discussing how balance sheets work, we show how to apply the lessons to the November 2007 balance sheet of Lehman Brothers—nearly a year before its collapse on September 15, 2008….

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Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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