Wednesday, September 2, 2009

Moral hazard and financial market crisis

At the peak of the financial market crisis, it was strongly argued that any government efforts to bailout struggling financial institutions was bound to generate moral hazard concerns with both immediate (among other similarly beleaguered institutions) and longer term (among all financial market participants) implications. Accordingly, after toying with the idea of bailouts on the face of pressure to prevent a systemic collapse, governments and central banks pull back, only to get back to bailing out institutions after experiencing a few bitter shocks as a result of the policy on non-intervention.

Guillermo Calvo describes this sequence of events as "triple-time inconsistent" policies and feels that such crises may be the wrong time to establish institutional credibility and fight moral hazard. Pointing to the examples of the emerging economy debt crisis of late nineties triggered off by the Russian debt default of 1998, and the sub-prime meltdown initiated (among other things) by the decisions to sell-off Bear Stearns and let Lehman go bankrupt in the second half of 2008 , he writes,

"First, a public institution is expected to depart from earlier statements and offer a bailout to prevent a major crisis (this is the first round of time inconsistency); then, in an attempt to regain credibility, the bailout is pulled back (the second round) and, finally, having witnessed the wreckage caused by the policy surprise, it resume bailouts of the still-standing dominoes (third round). This seesaw policymaking cannot be right. The initial refusal to continue offering bailouts can only be justified as a warning signal to market players against getting involved in situations in which they will need a bailout. But this 'investment in credibility' goes to waste as the policymaker chickens out and bailouts resume...

A financial crisis is not the best time for reform or building credibility, especially if those actions go against the private sector’s expectations. Policymakers should focus their attention on putting out the fires and minimise the short-run social costs."

This is another reason for limiting "too big to fail" institutions and leave no part of the financial markets outside the net of regulatory oversight. As was witnessed only recently, the extent and scope of system-wide uncertainty prevailing when a financial market crisis strikes is staggering. The challenge under such circumstances is not so much as to repair the situation, but to contain further damage from an avalanche of uncertainty and a cascade of confidence shocks.

The more markets slip down the slippery slope, the greater is the difficulty and longer the time required to get back to normalcy. Policy makers are therefore left with no alternative but to throw every available policy option in the hope that atleast some or a mix of them will have the desired effect, and that too at the earliest. Such times are surely not appropriate occasions for experimentation with selective use of policies and concerns with fundamental issues like moral hazard.

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