Thursday, December 22, 2011

Moral hazard

The president of the European Central Bank, Mario Draghi, warned in an interview in the Financial Times (19 December) of the cost and dangers of disintegration of the eurozone. Unlike his predecessor, who always refused to even countenance such a possibility, Draghi does not rule it out but says that the ECB buying up state debt is not a miracle solution to the crisis because countries themselves have to act first and is the only practical way of restoring confidence among investors.  In order to tackle the crisis, the ECB president says that unprecedented measures are needed, like the ECB's support for eurozone banks, for example, of unlimited three-year loans. This is intended to be lent on to the real economy to relieve pressure on small and medium-sized banks that provide the bulk of finance to small business  which make up 70% of private sector jobs in the eurozone.

Yesterday, the ECB offered to all eurozone banks unlimited liquidity at a 1% interest rate. Some economists think that this measure will allow banks to provide credit to enterprises, thereby alleviating the recession effects. Some others foresee that banks, attracted by the difference between the cost of borrowing and the interest rates on sovereign debt of Spain or Italy, will be tempted to use this source of liquidity to purchase bonds and speculate for profit.

This bears resemblance with  a moral hazard situation in which banks continue to take excessive risks and if things go wrong, the ECB and States will have to intervene to save them. In heavily indebted countries, the ECB operation is not the panacea, neither for enterprises, nor for the Treasury. In order to provide credit to enterprises ( or even purchase bonds), the bank should have the necessary liquidity, that is enough capital (net from loans already provided). Each loan entails specific risks:  the loan could not be reimbursed and State  bonds could lose their value as it happened a few months ago. In substance, to face these risks, banks should have enough free capital; if they don't have it, the ECB liquidity will not be useful. the problem is that many banks in Italy and Spain have little capital available, especially after the loss in value of State bonds. This is probably true for large banks, which are more heavily exposed, but it may not be the case for smaller banks which have been in the past more active in providing capital to small and medium businesses.

In substance, the ECB may help alleviate the effect of the recession but also create a moral hazard  that should be avoided.  Governments should use heir powers to ask banks to provide credit to enterprises. But it is not certain that they will do so as they failed to introduce strict financial regulation for the banking system. It is a pure illusion to think that the ECB is the solution to the eurozone crisis. Other measures, such as making the European Financial Stability Fund (EFSF) fully operational and increasing its lending capacity are certainly necessary. But the key to recovery is an ambitious plan of growth enhancing investments at the EU level which may stimulate demand and job creation. This seems to be a taboo for European leaders that we must breach to avoid the break up and disintegration of Europe with all its negative consequences on ordinary people and businesses.

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