Abu Dhabi, UAEWednesday 15 August 2018

Government bailouts come with a price tag

In times of financial panic and market uncertainty governments are pushed to act, but with potential long-term negative consequences.

In times of financial panic and market uncertainty governments are pushed to act, but with potential long-term negative consequences. The recent purchase of Bear Stearns by JP Morgan, and the Fed's takeover of the troubled mortgage providers Fannie Mae and Freddie Mac, involved the assumption of billions of dollars of possible bad debt obligations. The Bank of England did the same with Northern Rock. The results have been public disquiet over ill thought-out government bailouts at the taxpayer's expense.

History repeats itself, and in the financial sector this seems to be happening with alarming regularity. Take the US savings and loans crises of the 1980s and 1990s. More than 1,000 savings and loans institutions failed over that period, and the causes seem to be the same as those haunting the markets today. Greed, excessive risky lending, especially related to property, a lack of bank capital and a mismatch of assets and liabilities by financial institutions, coupled with outright fraud, were all primary contributors then and now.

Government bailouts do not come cheap. According to the US General Accounting Office, the initial mortgage related bailouts cost taxpayers about US$125 billion (Dh460bn). This time, the ultimate cost could be significantly higher, as recent reports indicate that the subprime meltdown could end up wiping out nearly US$1 trillion of bank assets. Given this generous government safety net, the risk of repeating costly mistakes and going unpunished is always inherent in the system. Economists call this moral hazard.

Thankfully, there seems to be a way out, and the insurance industry provides a potential answer. Most of us have taken out one form of insurance or another to protect against unforeseen risks. Every year we pay the insurance companies a premium. If we are extremely careful, the following year's premium might be reduced or held the same. If we are unlucky, we receive a payout, but unlike government bailouts this insurance payout is not free. We pay for this insurance.

Some will argue that government bailouts of distressed financial institutions are in a different league from personal insurance cover, as the potential damage to the overall economy and consumer confidence is substantially higher than the potential cost of government bailouts. The argument, however, can be reversed. Given the enormity of potential financial distress spreading among banks and other institutions, why not require them to purchase "bailout" insurance? The same common sense principle applies to us: we cannot obtain mortgage finance unless we have a fire insurance policy in place. This is our "bailout".

Who would charge this insurance to the financial sector? Central banks can be the actual or explicit insurers, as they are the implicit bailout insurers. Instead of becoming last-resort lenders, central banks might also become the insurers of first resort and force financial institutions to think twice before engaging in risky financial activities. As individuals, we are advised that insurance will not be provided if we engage in risky activities. Similarly, why not have such a warning sign for financial institutions? If some huge banks are "too big to fail", why not make the implicit government insurance explicit and charge them a premium?

Central banks would then require member banks to purchase insurance, at a price the central bank would set, and adjust this premium periodically based on an evaluation of the level of risk in a financial institution's holdings. Some might also argue that this would be an imperfect system, as insurance works best when insurers cover a large number of clients for events that are either highly unlikely, catastrophic or essentially unrelated to each other.

Despite some defects to the proposed insurance bailout system, there are benefits for its adoption. A central bank insurance bailout fund would be invested for the benefit of the insured "pool" of banks. In case of bailout payments, the fund would act as a reserve, instead of a 100 per cent taxpayer bailout. Also, the relative premium paid by the insured members would be public information, and act as a strong signalling mechanism to the marketplace regarding how a central bank perceives the level of risk for each financial institution. The raising of bailout insurance premiums would have negative consequences on a financial institution, and make it think twice before engaging in risky activities. Some institutions might not wish to make voluntary bailout insurance premiums to the central bank. Again, this action would be signalled to the market, causing other parties to hesitate before dealing with the non-contributing institutions. Implementing such a scheme would not be easy, because it would require an army of central bank risk assessors identifying risks that are disguised from auditors and the public. Some will argue that the financial system performs best when it is less regulated and innovative. Investment banks have prided themselves on their ability to manage risks and returns. The global regulatory framework was premised on that ability, but it has failed badly. Financial institutions did manage risks, but in a way that left them seemingly the winners, and wider society, including those repossessed of their homes, the losers. In such an environment, a signalling mechanism based on bailout insurance premiums might be a useful regulatory signalling tool to reduce the likelihood of future government bailouts. Dr Mohamed Ramady is a former banker and a visiting associate professor of finance and economics department at King Fahd University of Petroleum and Minerals in Saudi Arabia business@thenational.ae