Credit crisis comes to Australasia?

Following the freezing of Hanover finance’s finances we have heard that the National Australia Bank, and the Australia New Zealand Bank have both had to increase provisions for bad debt (NAB, ANZ).

These revelations put the relatively dovish stance of the RBA and the RBNZ in perspective – after all, central bankers are more than aware of the fact that the Great Depression was, at least partially, the result of a collapse in the banking sector which exacerbated a tightening in credit conditions. In a sense, the credit crisis in Australasia is now as bad as it has been in modern times – even if (arguably) things are improving in other parts of the world.

Even so, every time I attempt to pat the RBA or RBNZ on the back a couple of phrases come in the back of the head and prevent me, these phrases are “moral hazard” and “inflation”.

The inflation issue is simply – inflation has been allowed to crawl out of its hole (partially) by the dovish actions of the RBA and RBNZ over the past five years, as a result I don’t feel comfortable that we will get it back under control once this crisis is done. Allowing a “deeper” recession now may have actually been the best way to prevent significant hardship in the future – I guess we will see. Personally, I can see our economy rebounding from the September month of this year (in the absence of further positive or negative shocks – furthermore, I think seasonally adjusted quarterly activity will remain below December 2007 levels until either the final quarter of this year, or first quarter of 2009), a belief that leads me to a conclusion that we should be focusing more exclusively on the inflation menace.

The moral hazard issue is more specific to the current behaviour of the central banks. The commentators on this blog have argued about its relevance before (*), however in this case I think it is justified.

For five years, exporters have complained that high interest rates have made competing difficult, and the Bank did nothing. Now for a few months the Banks complain about their “margins being squeezed” and the RBNZ rides to the rescue – this alone seems a bit weird, when should a central bank be looking to bail out industries that can’t compete? Wasn’t this the dogma we followed when we removed tariffs on clothing and footwear?

Still ignoring the ideology, the helping out of Bank’s does cause a moral hazard problem. If the Bank’s know they will be bailed out when downside risks are realised, they will take on riskier ventures with a higher expected rate of return. All this ensures is that in the future either:

  1. The central bank does not help, and the probability of a bank collapsing is higher,
  2. The central bank does bail them out, and passes the risks that the retail banks have taken on back onto society

I don’t see either of these outcomes as either fair or efficient – so why are we doing it?

So the credit crisis is indeed in Australasia now. However, our central banks have to find a fine line between preventing output volatility now and allowing inflation and moral hazard issues in the future – a very difficult thing to do!

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  • CPW

    Aah, the RBNZ, it was only about 18 months ago that they were telling the banks that their margins were too low, and they should raise them.

    Still, I not convinced that this is really a moral hazard situation as you describe it. The banks are largely being hit by credit market problems not of their making, the only way they could have avoided the problems is by funding all mortgages out of domestic savings (which would require much higher interest rates). There is no suggestion as of yet that bank capital levels are inadequate.

    Isn’t the real moral hazard channel on the borrower side? People can take out excessive mortgages, knowing that the housing sector has too large an impact on the NZ economy for the RBNZ to allow interest rates to rise too high, or allow house prices to fall to far.

    I agree that exporters are probably feeling peeved right now though, even if the RBNZ’s actions are justifiable.

  • “Still, I not convinced that this is really a moral hazard situation as you describe it.”

    The banks will be willing to loan to a riskier pool of borrowers based on the fact that their downside risk is covered – won’t they?

    “Isn’t the real moral hazard channel on the borrower side”

    Indeed – it is on their side as well, good point.

  • CPW

    If the NZ banks failed and if the NZ government bailed them out then this would be a moral hazard. I don’t think any of them are remotely near failure though. The question is, if the RBNZ had credibly pre-committed to not lowering interest rates in the face of a credit crisis, would the banks have curtailed their marginal lending? I’m dubious that there would have been much of a change, ex-ante I suspect even the marginal loans had a positive expected value (which is what we’d expect if we go with the common assumption that the big banks aren’t operating in perfect competition).

    Or more formally, is a production subsidy to a monopolist welfare-enhancing? I can’t remember.

  • “I’m dubious that there would have been much of a change, ex-ante I suspect even the marginal loans had a positive expected value”

    Yes, but risk averse banks will now have an incentive to give out loans with a higher ex-ante variability in outcomes (higher risk), as their downside is covered – this is the moral hazard problem, and it exposes society to these risks (when they are risk averse) which has a welfare cost.

  • Nassim Taleb spoke out in Davos about banks and the moral hazard of bailouts.

    He and Nouriel Roubini were both interviewed at CNBC recently, but soundbite journalists are incapable of handling their views sadly.