Financial Commentary - Credit crunch and market failures

The world's politicians are having to come to grips with market failures. The credit crunch is, in itself, a market failure. The earlier lending boom was a market failure. And the likely effects - collapsing housing markets, imploding banks and rising unemployment - can also be regarded as market failures.

The key difficulty lies in knowing precisely how to react to these failures. Moral suasion clearly had little lasting effect. For much of this decade, central bankers and assorted international agencies warned of the dangers associated with excessive lending. Despite their warnings, however, excessive lending continued unabated, driving house prices and household debt in some countries up to extraordinary levels. Moral suasion, on its own, is typically not good public policy.

Banks continued to sell bundles of poor quality loans to unsuspecting investors. This is certainly a key part of the story. In the old days, banks could lend only to the degree that their deposits allowed them to do so. In modern financial systems, however, bank lending is no longer constrained by deposit growth. Banks can, instead, raise funds through securitisation, whereby they package loans up into bundles and sell them on to other investors. In this model, the limit on bank lending is not provided by deposits but, instead, by the willingness of others to invest in asset-backed securities and their various derivatives.

Until last summer, this was a very profitable business, helping to explain the increasingly lax lending standards which came to characterise the housing markets in the US and the UK. To guard against over-exuberance in this area, policymakers are now suggesting that banks should be required to hold higher reserves and that, meanwhile, there should be a very careful review of employee compensation (the upside for traders can be huge but the downside may be rather limited, thereby encouraging excessive speculation).

This approach, however, assumes that the banks are staffed only with vultures all-too-happy to pick over the carcass of a failed economy. The banks themselves, though, are at the epicentre of this latest financial earthquake and are not enjoying the experience one bit so it is not entirely clear that the institutions themselves are the only ones to blame.

The complication with the banks is, of course, that they make profits for their shareholders but equally provide benefits for society as a whole (it is difficult for any economy to function without a credit system). Thus, when they fail, there is typically a need to bail them out. It would surely have been wrong, for example, to allow the customers of Northern Rock to have lost their deposits through no fault of their own. Bail-outs, though, can protect precisely those people who took stupid risks in the first place, thereby encouraging even more risk-taking in the future. To deal with this moral hazard problem, regulators may insist that banks have to hold more funds in their reserves.

What, though, does this mean? The Basel II guidance, which provides the latest regulatory thinking, states that "a significant innovation of the revised Framework is the greater use of assessments of risk provided by banks' internal systems as inputs to capital calculations". That's all very well, but is hardly a cure for the kinds of market failures we have been seeing recently. Banks, after all, are being brought down by the actions of others. In these cases, counterparty risk (or, put another way, a loss of trust), not the size of reserves, is the issue at hand. Moreover, risk assessments themselves are prone to error. Financial innovation is generally a good thing, but makes risk a lot more difficult to gauge, as the ratings agencies now know at a significant cost to their reputations. Too often, regulators confuse risk with liquidity.

Underneath all these issues, though, is what we can call the "hunt for yield". As life expectancy has risen, the gap between official retirement age and a life expectancy has gradually got larger. All of us have to think harder about how, precisely, we are going to fund our ever-lengthening retirement. At the same time, though, many of us seemed to be hooked on credit, wanting to consume more and more today.

These competing pressures can only be reconciled if the assets we invest in offer ever-higher returns. And thus we have been living in an age where each new financial innovation is greeted with the enthusiasm once reserved for the alchemist.

New regulations have to deal directly with this issue. It is all very well offering moral suasion or controlling the activities of banks but unless something is also done about the hunt for yield, unscrupulous salesmen will continue to flourish in the ever-more-complicated world of financial innovation.

Regulators and policymakers need to understand this basic truth. That means better financial education for the masses and, whether we like it or not, a progressive increase in the age of retirement. If regulators and policymakers fail to deliver in these areas, we will simply end up with more bubbles, more false hopes and, ultimately, more impoverishment.

• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.