RALLY SHOWS MORAL HAZARD IS STILL ALIVE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

Rally shows moral hazard is still alive

Published: March 9 2010 22:05

Bank share prices have risen sharply from their nadir a year ago. But this is not a sign of underlying health; many of the world’s largest banks remain in a sclerotic state. In the US and UK, parts of the credit market only function because of the continuing intervention of taxpayers. To remove this precipitately would run the risk of another panic.

What the recovery really shows is the scale of the moral hazard problem the world still faces. Bank investors were not made to pay a big enough price for their folly during the credit boom. Apart from Lehman, only one large bank collapse – that of Washington Mutual – resulted in big losses for debtholders. In most cases even the shareholders, while diluted, were not wiped out. Market discipline has disintegrated and shows no sign of returning. Understandably so. While investors think they will not lose out, why should they constrain the activities of banks?

Governments have not played their hands as well as they might have done. They missed a trick in not imposing new rules when the banks were down. The US government was unwise to let banks extricate themselves from the Tarp (and its restrictions) before it had worked out what the new system should be. However, reform has not stalled altogether. And whatever form new regulations take, two elements are essential.

The first is haircuts on debt investors when losses overwhelm a bank’s equity. It could be done by having some bank debt convert into equity in defined circumstances. If the amount were big enough – say 20 per cent of the balance sheet – this would restore market discipline. The resulting bigger equity cushion should also reduce the risk of failure.

The second is a resolution regime that would allow losses to fall where they should without bringing down the system. This would prevent creditors from sheltering behind vital functions, such as the payments system, in a crisis and thus pushing losses onto the taxpayer. The regulator must have the ability to firewall these sensitive activities and guarantee them – while allowing the rest to fail.

Though these innovations are necessary, it is not enough just to announce them. Investors need to believe that they will in fact be triggered if needed. The only credible finger on the trigger is that of the regulator. In the case of very large banks, the scale of the resultant dilution and losses in the event of a conversion or seizure would be daunting. This is why bank size remains a live issue.

Copyright The Financial Times Limited 2010