Moral Hazard and Too Big to Fail

December 14th, 2011 by Rick Drain

Stop me if you’ve heard this one before:

A bunch of regular folks, and some who were irresponsible, borrowed money from banks. No one made the banks lend the money;テつ the banks did it to make a profit.テつテつ The banks even assumed that if the less-responsible borrowers got into trouble, then someone else could be coerced into paying the cost. テつ In retrospect, that is moral hazard.

The irresponsible borrower got to (really too far beyond) the limit, and had no real choice but default.テつテつ The other borrowers shrugged at first, then learned from the banks that the banks would be ruined by the default, which would ruin all the other borrowers, and basically all the rest of the world for good measure.テつテつ The banks told their governments that they needed to be ‘supported’ or some such euphemism for the good of the world economy. テつ That sounds like the banks were too big to fail.

Am I re-hashing the same old housing bubble?テつテつ Oh, no, not at all.

I’m talking this time about the Euro sovereign debt crisis. テつ For all the talk about the future of united Europe and the common currency and Mediterranean profligacy, this is the same story again, centered on Greece.

Germany’s Merkel was quite right when she said initially that Greek debt wasn’t the EU’s problem, it was Greece’s. テつ Then the phones in her office rang. テつ The European banks were calling to explain that

a) they didn’t want to take such a big loss, because it wasn’t really REALLY their fault, because they believed the Ratings Agencies, and the Agencies had said that Greek government debt was basically as sound as any other Eurozone debt.

Oh, and b)テつ if the banks had to write off the bad loans they’d freely made, they’d be insolvent.テつテつ They would fail, bringing the EU’s economy down with them.

Since those phone calls, all the talk of history and unification and ever-closer and whose responsibility was for what, or whatever, was all about protecting the banks from their own bad lending in order to protect the region’s (and possibly world’s) economy.

Three years on from the US bad-debt meltdown, it appears that no one has learned much, unless you propose that the banks have learned that they’re invulnerable as long as they can fend off meaningful regulation. テつ The banks still had extremely high loan:capital ratios, so they could maximize their profits at the oh-so-small cost of possibly holding the world hostage if their dodgy bets failed.テつテつ The banks were still huge, so the threat of their failure taking down all of Europe was real.

This time, could we actually have the reform that we knew was needed after last time?テつテつ Please?

No, probably not.テつテつ The banks have a lot of clout with the politicians on both sides of the Atlantic.テつテつ They will deny.テつテつ They will distract. テつ They will defend. テつ They will delay.

They won the first round, in the US. テつ They appear to be winning the second round, in Europe. テつ Can we get the electorates of these regions to put all their weight on the politicians, and get some reform? テつ You may hope, but don’t blindly believe.

You could, of course, fight.テつテつ You know it’s worth it, but you’re busy. テつ Maybe someone else will do it.

Longsplice rope

Something to look forward to:テつ Round 3 may be China.テつテつ That will be extra fun, with even less transparency, less popular power, and an even murkier boundary between the bankers and the government.