Friday, September 21, 2007

Why not let a bank collapse?

When I heard that the Bank of England had decided to bail out Northern Rock, I can't say I was all that impressed. From the column of the FT's Martin Wolf we have this interpretation($):

"Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage .... the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage"

Yes, I'll agree with that, but surely as the banks have acted irresponsibly this kind of intervention will do nothing to prevent them from continuing to do so in future?

Why not let a bank collapse? Isn't this the point of risk v. reward? You make big money by taking big risks. Remove the risk, and you wonder what these bankers were being paid to do.
Isn't the Bank of England letting Northern Rock have its cake and eat it too?

King's behavior illustrates the classic moral hazard argument - with the knowledge that their reckless behaviour will go protected by the central bank, there is no incentive to reduce their exposure to risk. The risk has, to a degree, been transferred away from the bank and back to the government - and ultimately to the man on the street.

But what about the bank's customers? The government protects the first 30,000 odd pounds worth of deposits by law. The mortgages and debt would be purchased by another bank - the loans are still good, and if bought at a discount would probably turn out to earn a tidy profit.