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. This is much more than simple a case of wanting to 'set an example' or to 'do the right thing'.

In essence, Moral Hazard relates to whether 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.

Of course, in this context, 'We' refers to the government, banking authorities and regulators, who act on our behalf, and 'reward' means shielding the financiers to some extent from the dire natural consequences of their actions.

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, perhaps precipitating such a disaster.

In our 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 they are somewhat contradictory. The first is that: the market is unrelentingly ruthless; the second is that it is often driven by psychology, and frequently somewhat irrational.

The first aspect is the real reason why we should be concerned about 'Moral Hazard'. History has shown that as soon as inconsistencies appear in a market, the market reacts - usually by finding a way to make money out of those fluctuations, and so exploiting, and sometimes eliminating them. Indeed this is one of the characteristics of what is known in technical terms as an 'efficient market'.

In simple terms, if the banks are bailed out, this could have two serious adverse effects: firstly that (when the dust has settled) banks would take the management of 'extreme' risk less seriously, and secondly that in the shorter term, financial engineers will 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 second feature of the market I have mentioned is the degree to which it is driven by psychology, often taking the form of irrational optimism or irrational pessimism. Since in financial terms, the value of an asset is not what we might think it is actually worth, but what 'the market' is prepared to pay for it, this feature often drives a 'feedback loop' which can create both momentum and volatility in the financial markets, which can be very hard to control.

So, given the serious and rather depressing nature of these discussions, where is the irony? - This has to do with the factors driving the longer-term money markets.

When the government gave the Bank of England control over the setting of interest rates, this was widely considered to be a particularly astute move, which had a number of benefits, both directly and indirectly. One of the main benefits was that the market quickly reacted to this change of regime by anticipating that, in the long term, the cost of borrowing money, and the volatility of this cost would be reduced.

This was largely because the market 'factored in' the fact that the Bank of England would make a better job of setting interest rates and controlling inflation, able to make more informed and objective decisions than elected politicians. This had a significant impact on the shape of the market's UK 'yield curve', especially for longer-term interest rates.

An indirect benefit therefore, was that the government was able to finance its longer-term spending more easily, and so more could be done with the taxpayer having to pay less - a 'win win' situation. Reasonable estimates suggest that the impact of this effect on government spending has been very significant, creating something of a 'windfall' for us all.

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 might ultimately interpret these measures as a sign of weakness, and penalise them.

This penalty could take the form of reduced confidence in the authorities, possibly resulting in a destabilisation of the UK yield-curve. This could lead to serious problems in long-term funding at exactly the time when this might really be needed.

The Governor of the Bank of England is obviously acutely aware of these factors, and one senses that he attaches significant weight to this issue of Moral Hazard. 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 talking about a possible return to 'boom and bust'. Since some of the mechanisms that have contributed to recent long-term stability might effectively be thrown into reverse, driving a destructive feedback loop, and resulting in a very unpleasant situation.

Sadly, much of what has been happening recently was entirely predictable. Unfortunately, despite increasingly robust warnings, nothing was done to defuse the situation, although it could have been.

However, there are some signs of hope and a good chance that the worst plausible outcomes can be avoided, although this is not guaranteed. To achieve this will require level heads and, in the terms so beloved by consultants, both 'strategic' and 'joined up' thinking.

Watch this space ...