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Risky business

Rules to prevent another crisis have to take into account the problem of ‘moral hazard’.

As the financial crisis claimed one victim after another, governments demonstrated how, in many cases, they were willing to step in with taxpayers’ money to shore up the system. Rather that, politicians thought, than let banks and other institutions collapse.

Now, as politicians attempt to come up with rules to try to minimise the likelihood of another crisis, they are wrestling with the concept of ‘moral hazard’ – where individuals, companies or institutions take decisions, trusting or hoping that others will bear the cost if things go wrong. As policymakers on both sides of the Atlantic draft a plethora of legislation, they are trying to find a way to instil the belief that a proper assessment of risk must be part of the new regime.

Many economists see moral hazard as one of the underlying causes of the sub-prime mortgage crisis in the US, where the securitisation of loans meant that concern about the size of lending risks became diluted between many different financial organisations, many of whom were not subject to the same regulatory oversight as banks.

As they try to learn lessons from the crisis, policymakers are trying to make sure that a proper awareness of risk plays its part in the new regulatory framework. During the crisis, governments gave an implicit guarantee that, in most cases, banks would not be allowed to fail because the knock-on effect could be disastrous.

As a result, many banks are now controlled by the state. This is where many observers – such as Mervyn King, the governor of the Bank of England and the vice-chairman of the European Systemic Risk Board – believe there is a problem. In a newspaper interview last month, King said the idea that some businesses cannot be allowed to fail “should have no place in a market economy”.

Bank failures

The European Commission thinks along the same lines. The challenge is to design rescue mechanisms for banks that are of systemic importance that will not create moral hazard. It is busy drawing up plans for a proposal on ‘bank resolution’ to be published this summer. It will set out how to let a bank fail in an orderly fashion without causing great shockwaves throughout the financial system. Commission officials are currently involved in discussions at G20 level in an attempt to arrive at similar proposals at a global level.

The bankruptcy of a major bank could put the whole financial system at risk, something that was seen in the

case of Lehman Brothers, the fourth largest investment bank in the US, which was declared bankrupt in September 2008. The Commission’s plans are based on equipping regulatory authorities with early intervention measures, allowing them to act as soon as problems are identified to ensure that appropriate measures are taken to try to avoid the bank failing. If there were judged to be no alternative, a framework for the orderly resolution of the bank would exist. “The whole idea would be to minimise the risk, in fact eliminate the risk, that the taxpayer would have to contribute to the saving of the bank,” an EU official said.

As part of the plan, the Commission is looking at the prospect of bank bail-ins, which would force banks to recapitalise from within rather than use public money. Commission officials have made it clear that they believe that had there been a bail-in in the case of Lehman brothers, with ‘haircuts’ being imposed on investors, the bank would not have gone into liquidation and the value of assets would have been maximised for everybody.

“We are looking into how to structure a system that would allow bail-ins to come in as an alternative to bail-outs,” said the EU official. “Instead of using public money, governments would be able to say they are restructuring the bank through the contribution of the shareholders and the bondholders.”

Bank resolution fund

An alternative suggestion, an EU-wide bank resolution fund financed by the banking industry and supported by Dominique Strauss-Kahn, the then head of the International Monetary Fund (IMF) when it was considered last year, has faded in the wake of objections from countries such as France and the UK. After all, any ring-fenced fund is likely to do little to protect against moral hazard, even in the unlikely event it could ever be large enough.

The question of moral hazard and “too big to fail’” is brought up in many of the proposed pieces of EU legislation. Take the plans to overhaul audit. The European Commission’s green paper on the issue looked at the possibility that a big accountancy firm could go bust, which would have a knock-on effect on the entire market. But instead of relying on taxpayers to pay for that failure, the Commission is trying to pre-empt any crisis by considering a number of proposals to break up the dominance of the major accountancy firms to reduce the impact if one did collapse.

Whatever the ultimate shape of the EU’s bank resolution framework and other proposals to reform the financial services industry, the aim will be to ensure that taxpayers are never again called on to pay for the mistakes of the gamblers.

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