Moral Hazard and market failures

In all the debate surrounding moral hazard, Lawrence Summers has presented an interesting view in his FT article, Beware moral hazard fundamentalists

While drawing the distinction between moral hazard in insurance from that in other sectors of the financial market, he argues for active intervention to enhance confidence and stability in the financial markets. Prof Summers defines three pre-requisites for Central Bank interventions
1. Possibility of contagion effects
2. A liquidity and not solvency problem
3. No cost imposed on the tax payer

Assessing each of the three pre-requisites, while appearing simple at first glance, presents considerable challenges. As I have outlined in my previous posts, the major challenge for Central Banks and policy makers is in recognizing the arrival of the tipping point at which the progress of events makes a contagion effect on the entire system inevitable. The recent Northern Rock fiasco threw up divided opinions on whether the crisis was confined to the Bank in question or threatened the entire financial system. In any case, it may not be reasonable to assume that independent Central Banks have some form of divine wisdom, inaccessible to others, in objectively deciding when a crisis threatens to spread across the system. In order to ensure greater transparency and objectivity, it may be desirable to identify certain parameters that are broad indicators of the contagion red-lights starting to flicker.

Recognizing whether the problem arose from a liquidity crisis or from solvency related issues, is easier, but would still throw up interesting dilemmas. The critical question here is who decides as to which firm or Fund is solvent and which not, and for what reasons? Credit Rating agencies were supposed to do precisely this, and have been shown up repeatedly when crisis struck. Surely Governments and the Finance Ministries cannot be expected to be objective and dis-interested judges in such suituations. So do we leave it to the Central Banks to decide it? If so, based on what economic parameters or financial indicators? Or do we strengthen the Credit rating agencies?

The third point is not so much a pre-requisite as a procedural concern. This point drives home is the distinction between free bailouts and those which impose the due economic cost. In other words, there cannot be any free lunches. Any bailout has to be at a cost, a prohibitive one at that, be it in terms of the cost of capital or the other terms of servicing or re-scheduling a loan. As Prof. Summers says, quoting Walter Bagehot, when acting as a lender of last resort, the Central Bank should "lend freely at a penalty rate against good collateral". A solvent firm or institution or even a Fund, facing a run in, is surely only facing a liquidity problem and its assets are a credible and good collateral. And this can happen to the best of financial institutions. If the firm is solvent, and is only facing a run in, for whatever reasons, then it makes sense for the Central Banks to intervene and arrange for loans, but at a high enough cost. In fact, the market should determine the cost of capital for re-scheduling the loan. If on the other hand, the firm or Fund is insolvent, then it should also be the sole yardstick for allowing it to default or collapse.

Prof. Summers' arguement against the oversimplifcation of moral hazard and using it to justify non-intervention in the financial markets, is an acknowledgement of the possibility of market failure in the financial markets. It is also a clear message to all those proponents of full capital account convertibility, free capital mobility, and extensive deregulation of the financial markets. Market failures are common in the financial markets and moral hazard is a major contributing factor, and such failures demand external intervention, by Government or its agencies!