The New Moral Hazard, DNA, September 2007

The phrase moral hazard is back in vogue today. Moral hazard in the financial sector is a situation where a deviant institution continues to take risky decisions knowing fully well that it will be helped out by the system in case of failure. Hence, banks can give into indiscretion in case they know that the cost of failure will finally be sorted out by the central bank. Now, the actions of monetary authorities across the world to tackle the sub-prime crisis have actually created this moral hazard. Let us see how this has happened.

The sub-prime crisis was a case where mortgage banks lent to home buyers with limited credit credentials at low rates and then sold them forward for securitization against which securities were issued to investors. As interest rates went up, the threat of default increased. Hedge funds were asked to put forth more money and when they tried to sell the mortgage backed securities their value had fallen. As no one knew where the risk lay and banks were reluctant to lend to one another and the funds dealing with these securities went bus. The Fed and the ECB started providing funds in the market to ensure that liquidity ws available which sent the signal that the monetary authority was willing to intervene to eschew a crisis.

The critics felt that this kind of intervention creates a moral hazard as institutions will use this as a precedent to be more reckless in future knowing that they will not be punished and a solution will be forthcoming from the Fed or ECB. To top it all the discount rate at which the Fed lends money directly to banks was also lowered which prompted all the big ones like Citi, Wachovia, JP Morgan Chase and Bank of America to borrow. And recently the Fed rate has been hiked on grounds of preventing the possibility of a recession in future and is not directly related to bailing out any institution.

Come over to UK now, and the Bank of England has done a similar act of protecting the Northern Rock Bank which though a mortgage bank had a different sort of problem. Its assets were secure but its funding channel got choked as it depended on the capital market and the commercial paper market for funds. This created a stir which got reflected in its stock value and was followed by deposit holders queuing up for their money. The BOE then entered to rescue the bank by not only providing insurance for the deposits but also providing funds against the security of the mortgages which were held.

Two questions arise here. Should these institutions be bailed out and the second is whether the central banks are justified in helping them out? The answer is equivocal here. If financial entities go overboard then it is not unlike a manufacturing concern which makes huge losses has no recourse. Hence for a bad business decision the consequences must be the same.

However, there are two points here. The first is that banks deal with public money and hence cannot be allowed to fail. Secondly, the fear of a contagion arises once one bank is allowed to fail. Therefore, the answer to the question posed earlier about whether the central bank should help out, the answer is yes. The central bank cannot stand by and let the crisis spread. If that is so, is there any way out? Here the Indian case needs to be put in the right perspective.

The Indian banking system is well governed with rules being placed on the lending pattern of banks. Lending to risky ventures like capital markets, commodities and real estate are ‘sensitive sectors’ and is not widely encouraged and is monitored closely. As over three quarters of the banking system is in the public sector, it helps to enforce this discipline.

We have however, had our own share of banking crisis, which have never really escalated to any kind of a contagion. Global Trust Bank had failed following the Ketan Parekh scam but the RBI found a way out through a merger with a public sector bank, Oriental Bank of Commerce. IFCI has been bailed out through financial infusion and subsequent equity sale. The lesser known Benaras State Bank was amalgamated with Bank of Baroda which in turn protected the deposit holders. But, yes, in case of the Ketan Parikh related Madhavpura Bank, the RBI did resort to provide finance to cooperative banks for short tenures to ensure that banking activities were not affected. But earlier following the Harshad Mehta scam in the mid-nineties, both Bank of Karad and Metropolitan Banks were liquidated.

Therefore, the RBI has also changed it approach to bank failures from a strict liquidation regimen just as we embarked on reforms to a more practical merger policy to one of accommodation depending on the circumstances.

An issue which comes to the forefront now is whether the sub-prime crisis could be repeated in India. We do not have such lending but given the large increase in the share of mortgages in the bank portfolio, there is a similarity. Also the fact that this portfolio has been built at a time when interest rates were low and are being re-priced today with higher interest rate regimes does highlight a payment problem for borrowers. Protracted repayment schedules and higher interest costs could affect the ability of borrowers to repay, which was the same with the sub-prime episode. But, the difference that can be seen today is that property prices are still high, which will prevent the value of the collateral from declining which was the case in USA.

The answer hence is quite clear. To begin with whenever public money is involved, the governance needs to be strong. Once in place, a failure should be protected to restore confidence of the public as well as safeguard their interests. But, this should hold only when public funds in deposits are involved, and not investors putting their money in hedge funds where the risks are known beforehand. There is hence need to distinguish between the two.