Moral hazard or good banking?

There is much debate about moral hazard. If the Bank of England offers more money to the clearing banks when they need cash, isn’t that bailing out banks who have lent too much to the wrong people? Won’t they just do it again and again?
No, that is not the case. The money markets have frozen. The banking system cannot sell good quality debt on to others at times in current conditions. If the Bank of England steps in if needed and buys some of the highly rated corporate paper and the better mortgages, it is not underwriting poor loans to people who cannot repay. It is keeping the system going when the markets generally have failed, owing to the fear that dominates and the flight to quality by the banks themselves.
I don’t want the Bank of England taking onto its own books poor quality loans that may turn out to be worth less than the deal price. I do want it to make cash available to good banks if and when it is needed, in return for good quality assets that would in normal times be easy to sell in the market close to their face value.
That seems to be what is emerging from the Bank. That will be most welcome, and will reflect what the Fed has been doing for the US banks for sometime.

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8 Comments

  1. Tim Skinner
    Posted March 21, 2008 at 11:53 am | Permalink

    Markets "freeze" when buyers and sellers cannot agree on a price.

    The buyers and sellers in this case are financial institutions, well aware of the nature of the trade and quality of the commodity.

    The problem is the sellers do not want to recognise the fall in value of their assets.

    There has been a massive expansion of credit into the property market which can no longer be sustained, because many borrowers have taken on more debt than they can afford. The expansion of credit drove up property prices, so even borrowers who could service their debts will not be able to afford the fall in capital value which is likely to ensue when the credit expansion ceases (as it is now doing). That expansion of credit is revealed as a malinvestment.

    The banks need both to stop and repair that malinvestment, which is why they cease to advance new credit and hoard cash. In time the wheels will start turning again.

    There is a fine line between Bank of England intervention to maintain "liquidity" and Bank of England intervention to create a false market in financial assets.

    This is especially so when the Bank buys the assets, rather than lending against them, which is what you propose, because in buying it is taking on the asset risk itself.

  2. Matthew Reynolds
    Posted March 21, 2008 at 1:52 pm | Permalink

    In this period of uncertainty you are right in what you have to say about how the Bank of England ought to tackle the problems in the banking industry . But one way to get the UK out of this socialist created mess is to cut CGT to one 10% flat rate , have a 15% corporate tax flat rate and an income tax flat rate of say 15% with the first £15,000 p/a exempt from tax altogether . But ending all tax concessions , credits , inwork payments and by growing public expenditure more prudently this could be phased in over say ten years . VAT could be replaced by a Sales Tax designed to reduce red tape and produce some extra revenue designed to help fund this radical programme . I think that tax reform can be used to ensure ten years of year on year improvements to our economy . All round the globe lower & simpler taxes have made things better – why not work the same magic in the UK ?

  3. Robert
    Posted March 21, 2008 at 2:03 pm | Permalink

    I have been very much in Jeff Randall's camp over the last year or so, and though I agree the Bank's first duty is protect the banking system, it must be careful from accepting all of the entreaties of the major banks who have been guilty in creating this mees a result of reckless lending. Yes John, the very same high street Banks's who lent at 3.5 up to 6x salaries (not just salary!) and loans of 100% up to 125% (with 25% unsecured) on LTV. Umm methinks that we do have a moral hazard here. I am all for profit, risk-taking and capitalism but not for bailing out those who have directly and indirectly created the problem we now have! The system has frozen beceause banks won't deal with each other, but nobody has come clean on the extent of how the virus of leveraged poor credit has infected their balance sheets. If the banks wrote the more toxic of their exposure down to zero combined with refinancing rights issues, this credit crisis will abate far more quickly than it will do otherwise. I find it much better to face a crisis head-on, admit the worst and take the necessary action rather than muddle through as the coterie of banks are trying to do! I am amazed how little the senior bankers/politicians really understood the seriousness of how the world had changed in the spring and then the summer of last year, breathtaking ignorance of what had been underwriting our golden period of growth over the last 5 years or so. The game had changed and now we reap the reverse effect of all that leverage . So yes I agree that the Bank must step in to do sensible things , but its firepower is limited and so is our governments as you well know. So my advice is to the Banks, come clean, raise the capital and then you and the financial system can move on otherwise this will whole process will continue to unravel layer by layer.

  4. apl
    Posted March 21, 2008 at 2:34 pm | Permalink

    JR: ¨No, that is not the case. The money markets have frozen.¨

    What you avoid saying here is why the money markets have frozen. Its because no bank knows if its competitor is solvent. If a company the size of Bear Stearns can go under, then any bank is a candidate to fail. THAT is the reason the banks don´t want to lend.

    We are no longer in a credit squeeze, this is a crisis of solvency. The assets of most of the Wests´ financial institutions are outweighed by their liabilities.

    Even if the Fed., and the Bank of England and the ECB, each squirt money into the financial institutions with a fire hose, they still have to pour money in faster than value is being destroyed.

    JR: ¨The banking system cannot sell good quality debt..¨

    And who in their right mind is going to buy debt at this point in time? Who has the money? No one at the moment can tell good quality debt from bad.

    JR: ¨If the Bank of England steps in if needed and buys some of the highly rated corporate paper and the better mortgages…¨

    The problem is nobody knows what highly rated corporate paper is worth, the credit agencies are a joke, often downgrading their ratings AFTER the event. Many of the credit ratings are just plain fiction. Bear Stearns was AAA less than 24 hours before the FED & JPM intervened.

  5. Matthew Reynolds
    Posted March 21, 2008 at 2:52 pm | Permalink

    In this period of uncertainty you are right in what you have to say about how the Bank of England ought to tackle the problems in the banking industry . But one way to get the UK out of this socialist created mess is to cut CGT to one 10% flat rate , have a 15% corporate tax flat rate and an income tax flat rate of say 15% with the first £15,000 p/a exempt from tax altogether . But ending all tax concessions , credits , inwork payments and by growing public expenditure more prudently this could be phased in over say ten years . VAT could be replaced by a Sales Tax designed to reduce red tape and produce some extra revenue designed to help fund this radical programme . I think that tax reform can be used to ensure ten years of year on year improvements to our economy . All round the globe lower & simpler taxes have made things better – why not work the same magic in the UK ?

  6. Robert
    Posted March 21, 2008 at 10:16 pm | Permalink

    It seems to take along time to moderate responses!

  7. Iain
    Posted March 22, 2008 at 2:10 pm | Permalink

    "I don’t want the Bank of England taking onto its own books poor quality loans that may turn out to be worth less than the deal price."

    But in light of the fact that the Rating agencies have been paid by the banks to rate their debt, a conflict of interest if ever there was, and banks unable to value the debt on their books, thus the credit crunch, how can the bank of England be sure they aren't being sold a pup by the Banks ?

    I listened to an interview on the Today program yesterday with Sir Peter Burt ex Chairman of HBOS who put forward irritating and patronising argument, suggesting the Bank of England should follow the FED and step in and take a wider range of Bank debt, making the slightly bizarre line of argument that Banks should be seen as something different from their management, for that management would held accountable for they would get the sack. Well we saw the accountability with the CEO of NR who on getting the sack went off and bought himself and his wife, his and hers Ferraris.

    So yes it achieves nothing trying to get even with the Banks for the swingeing charges they make against us for the temerity of having an overdraft for a few hours, and the Bank of England may have to accept a wider range of debt to get the Banks out of the hole of their making, but in light of the fact that this removes the ‘fear’ from the ‘fear and greed' equation, what are the Banks going to put up to replace the Moral Hazard cost because we can’t afford to let them go bust?

    Well perhaps we should take Sir Peter Burt’s suggestion, if we can’t hold the Banks accountable, may be we should hold the management accountable, and if a Bank wants the Bank of England to take less than AAA debt, the management should put their personal assets on the line as collateral, pensions, the lot, that would restore the Moral Hazard!

    There is one further step I would take, as stated there is little we can do with the Banks and credit markets in the fragile state they are, but when things get back onto an even keel, and in light of the Banks requiring the tax payer to step in as the risk insurer of last resort, the Banks and financial service industry should be invoiced for that service, some might call that an additional tax, but it would be remembered for they would see it in their bottom line.

  8. Bazman
    Posted March 22, 2008 at 7:12 pm | Permalink

    They might not intentionally rely on the bank of England to bail them out, but will be aware as a company that such insurance is in place.
    The directors of Northern Rock have done quite nicely out of such an arrangement, so why can't we? The precedent has been set.

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    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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