One of the most disturbing consequences of the Global Financial Crisis may well be its impact on distorting financial market incentives. It cannot be denied that the post-crisis bailouts and the unabated growth of Too-Big-To-Fail (TBTF) institutions, coupled with the persistent fragility of the global financial markets have entrenched the growing belief among the most influential market participants about a public bailout insurance.
MR points to the Bailout Barometer estimate of the Richmond Fed which shows that the share of private financial liabilities which appear to have explicit or implicit (based on past government actions and statements) government protection has grown to 61% as of December 31, 2014.
This 'financial safety net' constitutes the most credible 'smell test' of the systemic weakness of modern financial markets. It seriously erodes the market's disciplining powers and sows the seends for the next crisis. In light of the entrenched social beliefs, governments would need to go the extra mile to shake this settled wisdom. In fact, regulators have to establish a credibility of TBTF equivalent to the inflation-fighting credibility of central bankers.
Irrespective of whatever regulatory and systemic changes , such credibility comes only with decisive action to that effect during a crisis. But when faced with a crisis, financial market regulators and their political masters have hitherto preferred to elevate short-term considerations of preventing contagion over long-term incentive compatibility concerns. This stands in contrast to central bankers who have resisted the urge to reflate, even at the cost of significantly damping a growth cycle, when faced with inflationary pressures. Financial market regulators need to exhibit similar resolve and independence during a financial crisis to be able to reverse the trend of rising financial safety net and thereby create a healthier and more efficient financial market.
This assumes significance for India as it grapples with its bad loans problem. It is a great opportunity to definitively dispel the growing bailout moral hazard and let the markets punish greedy promoters and reckless lenders, even if it means a delay in the revival of the investment cycle.