Theme du Jour: Moral Hazard

One sign that market conditions are, at least temporarily, on the mend: both the Financial Times and the Wall Street Journal have stories on moral hazard. If you have time for sermons, things can’t be all that bad. And in confirmation, Asian markets are up solidly as of this hour.

Of the two stories on moral hazard, the Financial Times’, by Paul de Grauwe, professor of economics at the University of Leuven, is more insightful. The Journal story, “The Fed Treads Moral Hazard,” defines the problem, discusses Greenspan’s history of quick trigger rate cuts, and proffers that it is hard to know when and how much to act.

De Grauwe, by contrast, gives some ground rules:

Banks are at the centre of the payment system. When, for whatever reason, the payment system is disrupted the economy is bound to suffer. Trade and investment will be hurt. Sound banks and enterprises will be pulled down by an avalanche of defaults.

Thus, the payment system is a collective good. The central bank, as lender of last resort, is the ultimate guarantor of this collective good. This implies that in times of crisis it should provide unlimited amounts of liquidity to ensure the smooth functioning of the payment system.

That sounds simple enough. There is a problem, though. Central banks are responsible not only for the present but also for the future stability of the payment system.

Here central banks get caught in a dilemma of the proportions of a Greek tragedy. When, as happened last week, they dump large amounts of liquidity in the system, they also allow banks that did foolish things to get off the hook. And many banks did foolish things. Some loaned massive amounts of money to hedge funds without worrying about the risks they were taking or the degree of illiquidity of their positions.

In principle, the central bank can avoid this dilemma by providing liquidity only against good assets, thus excluding assets from banks that have got into trouble because of their own reckless actions. In practice it is very difficult to separate banks that merely experience a temporary liquidity problem from those that loaded their balance sheets with bad loans. This is especially true in the current crisis, when some banks announced losses but were unable to quantify them.

The dilemma creates two problems. First, it hurts our sense of justice: banks that acted irresponsibly are given the means to get away with it cheaply. Second, the stabilisation of the market today creates the seeds of future financial instability, because implicitly the central banks tell bankers that reckless behaviour will be punished lightly, inciting them to engage in such behaviour again. This is the moral hazard problem that economists stress so often.

There is no doubt that the present financial crisis has been created in part by previous rescue operations of central banks. These have lowered perceptions of risk in the market….

Could central banks have done more to reduce the moral hazard problem? Walter Bagehot, the great English economist of the 19th century, argued that in times of crisis central banks should provide liquidity only at a penalty rate. Last week the central banks did not heed this advice. Instead, at the slightest increase of the short-term rate above the target rate the banks, especially the ECB, flooded the market with liquidity. Yet nothing terrible would have happened if the ECB had allowed the short-term rate to settle to, say, half a per cent above the target rate of 4 per cent.

Of course, a small penalty rate would not have solved the moral hazard problem; but it would have signalled the seriousness of the central bank in facing up to it.

More drastic reforms will be necessary. Banks have increasingly been involved in activities outside the supervisory and regulatory framework. They have done so by offloading part of their riskier activities to hedge funds. Banks that engage in such activities should not expect to enjoy the automatic insurance provided by central banks without accepting that there is a price to pay for this. The price is that these hedge fund activities are brought back into the same framework of supervision and regulation as the other banking activities.

This will not be easy, because it involves a difficult exercise of international co-operation. It is imperative, though, to maintain financial stability in the future.

Things are going to have to get far worse for the sort of reforms that de Grauwe proposes to get serious consideration, much the less implemented. They call for constraint on bank investments and regulation of hedge funds, which in turn calls for an international meeting of the minds.

An illustration of how hard it is for even modest and strictly domestic reforms implemented: the US S&L crisis illustrated the dangers of partial regulation. Banks could always attract deposits by virtue of FDIC insurance, no matter how stupidly they invested the money.

Since banks had demonstrated they couldn’t be trusted with deposits, various proposals were advanced. One of the most elegant came from Lowell Bryan, then a partner in McKinsey’s financial institutions practice and widely recognized as a banking industry expert: Segregate the depositary business and require it to invest only in very safe assets like Treasuries. That was too good an idea to get any further than the op-ed page of the Wall Street Journal.

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