A V Rajwade: Central banks and moral hazard

It seems market fundamentalists want freedom only so long as markets are favourable.

One organ of the state which even market fundamentalists rarely criticise is the central bank; the general comment is subject to some provisos:

they should be autonomous, i.e. free of any political interference (full autonomy is of course a myth; even the Bundesbank could not avoid the east German mark being converted at parity to the Deutsche mark, at the time of German unification);

they should follow a reasonably conservative monetary policy; and

they should not intervene in the exchange market.

One manifestation of this reverence of market fundamentalists for central banks was the headline of a recent leader in The Economist (October 20th 2007): "Central banks have worked miracles (i.e. keeping inflation low) for 30 years". One had thought that miracles are what happen but rarely! Or is it that when the central banks do not do something patently foolish, this itself is a miracle?

The provocation for these thoughts is the way the Bank of England changed its stance on lending money to Northern Rock so quickly. On September 12, the old lady of Threadneedle Street wrote to the Chairman of the Parliament's Treasury Committee: "the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept....central banks, in their traditional lender of last resort (LOLR) role, can lend against 'good collateral at a penalty rate' to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate." The stand could not have been more unambiguous, and should have warmed the heart of all market fundamentalists. As is well known by now, in less than a week of making brave statements about "moral hazard" etc, the BoE was forced to lend money without "good collateral" (i.e. government paper), or "at a penalty rate", and that too on a massive scale; when the crunch came, Keynes triumphed over markets. The curious aspect of the whole affair was that there was no protest from market fundamentalists about the rescue of Northern Rock with public guarantees and money. It seems that market fundamentalists should be left free to make money so long as markets are in their favour, but should be rescued when the bets turn sour: remember the anguished cry of a hedge fund manager I quoted in my article dated September 10th, 2007? ("Bernanke is being an academic! It is no time to be an academic ... He has no idea how bad it is out there. He has no idea!... My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing... The Fed is asleep!"). Clearly, market players like the central banks to possess "the resources to save us from our own mistakes", as John Kay said in the Financial Times (November 14).

In fact "moral hazard" is inherent in the way banks function: on the one hand between banks and their rescuers, and on the other between bank traders and shareholders. As for the first, the run on Northern Rock was not so much on the part of the depositors, at least at first, as on the part of "the wholesale funders, other banks or money market funds lending to Northern Rock" (Governor in a BBC radio interview). In the same interview, the Governor described the moral hazard very clearly, quoting other, more conservative bankers "But now, because we were more prudent in the past, now we can expand. If you bail out the banks that took the risks then you'll undermine any incentives that we had to be prudent." But that is exactly what he did (to be sure, the shareholders would suffer when the bank is sold, but not the wholesale market lenders). He also justified it from the bank's angle: "If you're drowning, you'd prefer someone to rescue you than to demonstrate that you can't swim by drowning." One thought: when wholesale lenders made a run on East Asian economies, and there occurred a series of balance of payment crises at a lot of cost to the people of those countries, this was blamed on "crony capitalism", on weaknesses of the domestic financial systems, etc. Such contemptuous terms and sweeping generalizations have not been made in relation to what happened in the credit market.

But this apart, let me turn to the second moral hazard inherent in modern banking: an increasing percentage of profits is being earned in "trading". The more correct description of the activity is of course speculation: in currencies, bonds, equities and derivatives. The traders (i.e. dealers) get bonuses depending on the profits they earn for their employers; the losses, when they come, are borne entirely by the shareholders. Despite the huge losses reported by most banks recently, Wall Street bonuses are going to increase to $38 bn! Does this skewed risk-reward relationship for the traders lead to the moral hazard of taking undue risks?

But coming back to bank rescues, given the ever-increasing dependence on trading profits, the question is whether public resources including deposit insurance, should be available to such banks: in effect, a part of the bank acts like a hedge fund, while the other continues the traditional business of banking in the same legal entity. In the case of Northern Rock, a huge amount of short-term, wholesale market funding was used to finance long-term assets, a standard hedge fund strategy, in anticipation of securitisation. The many, bank-sponsored special investment vehicles financed investment in credit derivatives through short-term asset-backed commercial paper; the investments are now being taken back on the books of the sponsoring bank. In short, most major banks are today combining hedge fund-like activities, with traditional deposit and loan banking. Perhaps a time has come to consider whether public support and deposit insurance should be limited only to those banks who are not unduly dependent on hedge fund like, highly speculative activities.