Moral hazard in financial markets
Central bankers have been worrying for a number of years about the degree of excessive risk-taking within the financial system
Should you, at times, protect the innocent even though you may be letting off the guilty in the process? When policymakers consider such issues they usually turn to the ethics of utilitarianism, typically defined as the "greatest happiness of the greatest number." For those who govern, it has the advantage of allowing decisions by numbers. Policymakers can think in terms of costs and benefits and reach a conclusion which offers the illusion of objectivity.
Policymakers' responses to the sub-prime crisis and the possibility of a credit crunch will, ultimately, depend on their views about the protection of the innocent and the punishment of the guilty. Admittedly, the choices will not be quite as wrenching as those faced in other spheres of public life but it is already becoming apparent that the utilitarian calculations shaping policy decisions are beginning to shift. At first, the attitude towards the sub-prime problems was one of zero tolerance. There would be no bail-out because both lenders and borrowers should have known better. In a matter of days, though, policymakers' attitudes began to evolve.
When things first started to go wrong, the crisis was lodged firmly within the banking system. Many banks and other financial institutions owned collateralised debt obligations (CDOs), one of a variety of structured products. The values of some of these structures were underpinned by sub-prime debt. These underpinnings clearly were not terribly strong. It was not long before faith in asset-backed collateralised debt obligations was gone and, with it, liquidity dried up. No one wanted to lend to anyone else, because no one knew what exposures others had to CDOs and, indirectly, to the riskier end of the US housing market.
Liquidity crises, though, do not discriminate well between those who deserve to go bust and those who do not. Although, at first, the attitude from central bankers was not to get involved, this approach quickly mellowed as the dangers of a liquidity crunch became all too clear. Central banks injected liquidity, the US Federal Reserve cut its penalty discount rate and the liquidity crisis began to ease. The debate has since moved on. The big fear now is the onset of a credit crunch. In simple terms, a credit crunch can be regarded as a tightening of monetary conditions for a given level of policy rates. In other words, lending standards in the financial system tighten independently of any decisions made by the central bank.
For the man or woman on the street, this may imply higher borrowing costs, bigger required down-payments for the purchase of a property, a lowering of maximum income multiples for mortgages, tougher foreclosure conditions and so on. Put another way, even if interest rates are not particularly high by historic standards, the ability to borrow (and to renegotiate terms on a favourable basis) is reduced.
This, in turn, may have a series of negative effects on the broader economy. If people cannot borrow so easily, demand for consumer goods and services may begin to decline. Tighter mortgage terms may mean people have to spend more of their income repaying their mortgage, leaving less available for the trip to the local restaurant or ball game. In time, these downward multiplier effects may lead to rising unemployment and, eventually, the onset of recession.
It is for this reason that the US administration chose to step in. Proposals to expand the role of the Federal Housing Administration in order to help with the refinancing of sub-prime mortgages and the call for lenders to show greater flexibility towards some of their more distressed customers, are recognition of the potential severity of a possible crunch.
Soothing words, perhaps, but they do not quite deal with the underlying policy problem. Central bankers (more so in Europe than in the US) have been worrying for a number of years about the degree of excessive risk-taking within the financial system, whether reflected in rapid money supply growth, incredibly high correlations of returns across both asset classes and geographies, the innovation of structured products or the emergence of private equity. The makings of a credit crunch may be evident now, however, it seems its foundations were laid during the earlier credit "bubble" - when financial conditions were unusually lax for a given level of official interest rates. Perhaps central bankers were also in the wrong, refusing to raise interest rates quickly in the light of the US housing bubble (and similar housing bubbles elsewhere), all too happy to argue publicly that the gains in house prices were simply a reflection of welcome financial innovation rather than of lax lending standards.
If a credit crunch develops, it will ultimately reflect a revised view of the risks associated with the various products that sprang up in the earlier credit boom and which did so much to secure a healthy growth rate and a high level of employment in the US. At the moment, there is no desire to provide any bail-outs for the institutions which now are seen to be at the epicentre of additional risk-taking.
As Ben Bernanke, chairman of the Federal Reserve, put it, "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."
Fine words and, for the most part, entirely understandable. A bail-out of the reckless, the gullible and the unscrupulous should not really be part of public policy. It creates the classic moral hazard problem, allowing people to believe that the public purse will always be opened to "reward" bad behaviour, thereby encouraging people to take stupid risks. At the end of the day, though, people know that the economy, or the banking system, is "too big to fail". After all, the savings and loans industry was bailed out from 1989 onwards, even though its problems resulted, once again, from the behaviour of the reckless, gullible and unscrupulous.
In wartime, policymakers have to accept the death of innocents. In peacetime, society demands the protection of the innocent. Sometimes, though, it is not possible to provide that protection without bailing out the guilty. The moral hazard problem will not easily go away.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Policymakers' responses to the sub-prime crisis and the possibility of a credit crunch will, ultimately, depend on their views about the protection of the innocent and the punishment of the guilty. Admittedly, the choices will not be quite as wrenching as those faced in other spheres of public life but it is already becoming apparent that the utilitarian calculations shaping policy decisions are beginning to shift. At first, the attitude towards the sub-prime problems was one of zero tolerance. There would be no bail-out because both lenders and borrowers should have known better. In a matter of days, though, policymakers' attitudes began to evolve.
When things first started to go wrong, the crisis was lodged firmly within the banking system. Many banks and other financial institutions owned collateralised debt obligations (CDOs), one of a variety of structured products. The values of some of these structures were underpinned by sub-prime debt. These underpinnings clearly were not terribly strong. It was not long before faith in asset-backed collateralised debt obligations was gone and, with it, liquidity dried up. No one wanted to lend to anyone else, because no one knew what exposures others had to CDOs and, indirectly, to the riskier end of the US housing market.
Liquidity crises, though, do not discriminate well between those who deserve to go bust and those who do not. Although, at first, the attitude from central bankers was not to get involved, this approach quickly mellowed as the dangers of a liquidity crunch became all too clear. Central banks injected liquidity, the US Federal Reserve cut its penalty discount rate and the liquidity crisis began to ease. The debate has since moved on. The big fear now is the onset of a credit crunch. In simple terms, a credit crunch can be regarded as a tightening of monetary conditions for a given level of policy rates. In other words, lending standards in the financial system tighten independently of any decisions made by the central bank.
For the man or woman on the street, this may imply higher borrowing costs, bigger required down-payments for the purchase of a property, a lowering of maximum income multiples for mortgages, tougher foreclosure conditions and so on. Put another way, even if interest rates are not particularly high by historic standards, the ability to borrow (and to renegotiate terms on a favourable basis) is reduced.
This, in turn, may have a series of negative effects on the broader economy. If people cannot borrow so easily, demand for consumer goods and services may begin to decline. Tighter mortgage terms may mean people have to spend more of their income repaying their mortgage, leaving less available for the trip to the local restaurant or ball game. In time, these downward multiplier effects may lead to rising unemployment and, eventually, the onset of recession.
It is for this reason that the US administration chose to step in. Proposals to expand the role of the Federal Housing Administration in order to help with the refinancing of sub-prime mortgages and the call for lenders to show greater flexibility towards some of their more distressed customers, are recognition of the potential severity of a possible crunch.
Soothing words, perhaps, but they do not quite deal with the underlying policy problem. Central bankers (more so in Europe than in the US) have been worrying for a number of years about the degree of excessive risk-taking within the financial system, whether reflected in rapid money supply growth, incredibly high correlations of returns across both asset classes and geographies, the innovation of structured products or the emergence of private equity. The makings of a credit crunch may be evident now, however, it seems its foundations were laid during the earlier credit "bubble" - when financial conditions were unusually lax for a given level of official interest rates. Perhaps central bankers were also in the wrong, refusing to raise interest rates quickly in the light of the US housing bubble (and similar housing bubbles elsewhere), all too happy to argue publicly that the gains in house prices were simply a reflection of welcome financial innovation rather than of lax lending standards.
If a credit crunch develops, it will ultimately reflect a revised view of the risks associated with the various products that sprang up in the earlier credit boom and which did so much to secure a healthy growth rate and a high level of employment in the US. At the moment, there is no desire to provide any bail-outs for the institutions which now are seen to be at the epicentre of additional risk-taking.
As Ben Bernanke, chairman of the Federal Reserve, put it, "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."
Fine words and, for the most part, entirely understandable. A bail-out of the reckless, the gullible and the unscrupulous should not really be part of public policy. It creates the classic moral hazard problem, allowing people to believe that the public purse will always be opened to "reward" bad behaviour, thereby encouraging people to take stupid risks. At the end of the day, though, people know that the economy, or the banking system, is "too big to fail". After all, the savings and loans industry was bailed out from 1989 onwards, even though its problems resulted, once again, from the behaviour of the reckless, gullible and unscrupulous.
In wartime, policymakers have to accept the death of innocents. In peacetime, society demands the protection of the innocent. Sometimes, though, it is not possible to provide that protection without bailing out the guilty. The moral hazard problem will not easily go away.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.