Fed bailouts and moral hazard

US Treasury Secretary Hank Paulson said today in a talk that the Fed does not have the authority, nor has the mandate to, bail out non-bank financial institutions that find themselves in financial distress.

In a trend that started with Long Term Capital in 1998, to Bear Stearns early this year, financial markets have come to expect the Fed to come and bail out troubled large financial firms institutions, with the rationale that there are firms too big to fail. With the financial markets more inter-connected than ever, there is widespread belief that a failure by a large counter-party is bound to spread to the rest of the financial system, and hence, widespread sentiment that prudent policy dictates lifelines be extended during times of trouble for said privileged firms.

As Secretary Paulson correctly points out, this has created a breakdown in market discipline, as market participants took on larger and riskier bets, with the expectation of benefiting from the higher potential up-side, while being bailed out by taxpayer money in the event of a down-side. A moral hazard, in short.

This mentality is reflected in the compensation structure of many of these larger firms, where top traders are paid out a percentage of profits, but do not share in the losses when markets turn against their positions.

Secretary Paulson then went on to explain that there should be a mechanism in place that would preserve market stability during times of financial downturns, while at the same time not contribute to the breakdown of market discipline and engender a sense of riskless betting in the market.

Specifically what he points out is that US banks (and particularly non-bank financial firms) should be allowed to go into bankruptcy, and the Fed should no longer be expected to automatically inject money to save them. This will allow the courts and the markets, rather than policymakers, to make the crucial decisions of allocating capital in distressed situations.

I couldn’t agree more. This policy decision may have repercussions and backlashes in the near-term, as many investment banks face the prospect of bankruptcy, given the turbulence ahead. This will, however, reduce the risk-taking appetite of the market and engender a more prudent investment culture among investors and bankers.

There can be no way out of bad decisions. Bad decisions made by financial institutions are no exception. They will have to suffer the consequences so that in the future, they will learn to stay clear of unmanageable risks, and cut losses immediately once internally-acceptable risk parameters are breached.

As a Treasury Secretary who used to be part of the financial system that created this market culture, it is good to know he has this stand. No longer should already scarce government funds be used for bailout, and no longer should the already suffering taxpayer be forced to pay for failure caused by unrelenting greed and carelessness of a small group.

Banks will be allowed to fail. I can almost hear the most speculative funds scampering away from investment banks as I write these lines.

We all await Secretary Paulson’s further elaboration of this new policy direction.