Moral hazard awareness

Wednesday, August 27

Central bankers on August 21-23 met in Jackson Hole, Wyoming to discuss the state of the global economy.  The focus on regulation and improved monitoring seems to support the idea that monetary policy tools alone cannot prevent more financial crises, or mitigate their effects on the real economy. The current crisis has brought to the forefront a number of issues debated by economists for years -- such as whether monetary authorities should react to asset price bubbles. The banks have followed the academics in one sense -- they have not agreed on what is the best course of action.  However, one point of agreement from all participants was the need to remove any incentives for moral hazard in the system -- ie an end to the 'too big too fail' doctrine which forced intervention in both the United States (Bear Sterns) and United Kingdom (Northern Rock). Meanwhile, traditional problems of incentive structures and internal controls in banks have continued to arise. In the current situation, bank leverage has acted as a constraint on principal-agent governance problems in asset management, but it has also allowed bank-specific problems to propagate to the wider economy.

A crucial -- and almost-overlooked -- point is the need for much closer international regulatory coordination if systemic risk is to be properly gauged in highly integrated international capital markets. Also the differential effects of a crisis: for example, Japan is at present relatively unaffected by the credit crisis, but is instead suffering from the global rises in commodity prices.

This, in turn, raises the issue of contagion. Large advanced economies such as the United States might not be at significant risk, since bailouts are still conceivable, if extremely costly. However, smaller economies such as Switzerland and Belgium -- which are home to large international banks with assets far in excess of GDP (eg UBS and Fortis, respectively) -- can easily be affected by malaise in foreign markets. As such, the European Central Bank and the BoE have to be quick to identify systemic problems in order to prevent contagion freezing European and other global capital markets with severe consequences for the real economy.

There are clear frailties in both national and global financial architectures. Central bank bailouts of institutions such as Northern Rock and Bear Sterns may well have been necessary, given the novelty of the crisis at its outset, and uncertainty surrounding its long-term repercussions. However, as the crisis moves into a second year, extending credit and putting support in place to other institutions must be done carefully. These measures can only be temporary, as they could reintroduce moral hazard into a financial system that is still coping with the outcomes of previously lax regulation and loose monetary policy.