The most effective control is other parties’ diligence in assessing the businesses with which they deal.
There are good reasons why governments should not guarantee the liabilities of any private sector business. Such guarantees are likely to cost money and, in the case of banks, a lot of money.
There are three less obvious but also powerful arguments against such provision. The first is that such guarantees distort competition. Those who benefit will outperform rivals, not because they are more efficient or better at serving customers, but because they have access to cheaper capital. The second argument is that if government relieves companies of business risk, more risk will be taken. This is moral hazard. The third issue is that government intervention gets in the way of private sector initiatives, internal and external, to manage risk, which might be cheaper and less intrusive.
These arguments are compounded when the guarantees are implicit rather than explicit. When no one can be quite sure what is underwritten and what is not, certainty is not achieved, but the costs may be very large. Moral hazard may be exaggerated: if you are in trouble, you want the trouble to be bad enough to require rescue.
The consequences of these ill-defined guarantees made Fannie Mae and Freddie Mac particularly grave disasters. Neither truly private entities nor public agencies the businesses enjoyed a competitive advantage in both mortgage markets and wholesale money markets, accumulated absurdly large balance sheets on the strength of inferred government guarantees and finally cost US taxpayers billions of dollars after enriching the executives who led them to ruin.
The distortions of competition are extensive. Icelandic banks in 2007 bolstered deteriorating balance sheets by offering the best rates available to small savers in Britain and Germany. Today, the same advantage is enjoyed by high-street operations of conglomerate banks. In the absence of government guarantees, wise depositors would shun their incomprehensible balance sheets in favour of narrow banks.
But distortions are not only serious in retail markets. “Too big to fail” is a powerful barrier to entry, because no newcomer to an industry begins by being too big to fail. The lending operations of banks are profitable once more – who couldn’t trade profitably if the government underpinned their liabilities? Pity Warren Buffett, whose debt is downgraded because his well-run insurance business remains in private hands while his principal competitor, the failed AIG, basks in the credit of the US Treasury.
Some people claim the problem of moral hazard is exaggerated. If banks’ senior executives were bad at risk management – and they were – it was not because they lacked incentives. Many lost their jobs and reputations, and shareholders lost most of their money, even though the institutions were bailed out. But this misses the essential point.
In financial services, the principal mechanism of risk control is self-regulation by the sector. Such monitoring and underwriting can be achieved through central settlement systems in exchanges, and through derivatives trading companies and other intermediaries, which net out the effects of complex transactions. The more the government guarantees counterparty risks, the less the need for private sector actions. Too big to fail once more blocks the market.
But the most effective control is other parties’ diligence in assessing the businesses with which they deal. That is what atrophied in the run-up to 2007, allowing Lehman Brothers, with other investment banks, to gear up to 40 times its capital, and Northern Rock to become the largest player in UK mortgage origination. The failure to exert proper diligence was the product of optimistic beliefs about what regulation and complex risk-control mechanisms could achieve, the nationalisation of many mechanisms of self-regulation, and the inappropriate delegation of regulatory responsibilities to rating agencies, combined with the hubris that is part of every era of financial folly. But instead of renewing these self-regulatory mechanisms, we have effectively abolished them. That will prove an expensive choice.