The Significance of 'Moral Hazard'

We have recently heard quite a lot of Moral Hazard, a term with which most people, perhaps even some in the banking sector, will have been previously unfamiliar.

Unfortunately, this term does have the ring of a term from a Philosophy text book, but relates to something far more significant and, under current circumstances, rather more serious.

In essence, Moral Hazard relates to whether companies, including banks, should be allowed to fail as a result of making poor decisions. In contrast, by helping out banks and other financial institutions that have got themselves into trouble, we effectively reward those who have made poor judgements and who have taken irresponsible risks. This is much more than simple a case of wanting to 'set an example' or to 'do the right thing'.

This poses a dilemma for the authorities: the effect of a widespread collapse in the banking system would be catastrophic, and raises such a spectre that it must be avoided at almost any cost. However, there are a couple of other factors that need to be weighed up, in order to avoid making the current situation worse, and indeed, in the longer-term, perhaps precipitating such a disaster.

Markets Can Be Both Ruthless And Irrational

In the author's opinion there are two features of the market that have to be taken into account, and this is not made any easier by the fact that at first sight they might appear somewhat contradictory. The first is that: the market is unrelentingly ruthless; the second is that it is often driven by psychology, and therefore frequently irrational.

If the banks are bailed out, this could have several serious adverse effects. Firstly, that (when the dust has settled) banks would take the management of 'extreme' risk less seriously. Secondly, that in the shorter term, financial engineers might find a way of exploiting this support, effectively draining away money from the supporting authorities into their own pockets.

Anyone naive enough to think that this would not happen, if it were possible, need only consider Britain's ejection from the ERM. In that case the currency markets were the conduit by which a great deal of money were extracted from the public purse, and relocated in the profit margins of a number of finance houses.

Nowadays, the range of financial engineering tools available, specifically including complex credit derivatives, mean that in the present circumstances, the authorities should tread very carefully indeed to avoid writing the financial engineers a blank cheque.

The Irony of Moral Hazard

So, given the serious and rather depressing nature of these matters, where is the irony?

This has to do with the factors driving the currency and money markets, particularly in the long-term.

Here is the unpalatable irony of the situation. If the authorities act to help, by propping up banks and financial institutions in an innapropriate way, then the market in which these same institutions participate will ultimately interpret these measures, and their inevitable cost, as a sign of weakness, and penalise them.

This would take the form of reduced confidence in both the authorities and the financial system as a whole, partly due to the huge support that would have to be committed in order to save poorly run institutions that have become 'too big to fail'.

This would then probably result in a weakening of the currency, and a need for massive budgetary adjustments in the future, possibly resulting in a destabilisation of the UK yield-curve. This could, in turn, lead to serious problems in long-term funding of debt at exactly the time when this might really be needed.

The Governor of the Bank of England is obviously acutely aware of the significance of 'Moral Hazard' in a healthy financial system, and one senses that he attaches significant weight to it. Given what is at stake, we have been a little surprised by some of the criticism that has been levelled at him in this regard.

The stakes are rather high. In our opinion we are not just facing a possible return to 'boom and bust'. Since some of the mechanisms that have contributed to recent long-term stability might now effectively be thrown into reverse, driving a destructive feedback loop, and resulting in a very unpleasant, and perhaps almost unrecoverable situation.

However, there are some signs of hope and a good chance that the worst credible outcomes can be avoided, although this is not guaranteed - in the present situation this worst credible outcome is a complete collapse of the Western financial system and a global depression.

To achieve a more positive outcome will require level heads and, in the terms so beloved by consultants, both 'strategic' and 'joined up' thinking.

Watch this space ...