Christian Noyer: No moral hazard - the banks are doing their job
Comment by Mr Christian Noyer, Governor of the Bank of France, in the Financial Times,
18 September 2007.
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In recent weeks, Central Banks in Europe and the US have acted repeatedly to provide
liquidity to interbank money markets. These interventions have raised some questions.
Concerns were expressed that monetary authorities were bailing out speculators, thus
creating the same kind of moral hazard that may have led to excesses in the past. There
were also concerns as to whether the integrity of monetary policy would be compromised.
These are valid questions. On numerous occasions, in the past, we pointed out the potential
dangers that mispricing of credit risk posed for financial stability. We may be now seeing
some of the consequences. Excessive risks were taken, and losses will have to be accepted.
It is important that monetary and financial authorities take no action that would prevent this
process from running its course, let alone be seeing to be condoning past or future excesses.
However, the logic behind recent interventions is different. Put very simply, financial
turbulence and uncertainty have suddenly triggered an upward shift in the demand for
Central Bank money. Faced with such a shift, whose direction is apparent but amplitude
uncertain, the choice, for monetary authorities, is clear: either accommodate, and provide
temporary liquidity; or not, in which case, interest rates would have to rise to restore balance
in the interbank market.
Standard economic theory dictates that, in such circumstances, exogenous changes in
money demand should indeed be accommodated. In a seminal article going back to 19701,
William Poole showed that, when there is uncertainty about money demand, the optimal
response is to stabilize the interest rate, thus letting money supply adjust. Since short-term
interest rates are, for all Central Banks, the main policy tool, an increase in interbank rates
over and above the official rate would indeed be tantamount to a shift in monetary policy. In
contrast, liquidity provision by Central Banks has ensured that the overall policy stance has
remained unchanged. A clear distinction has been - and will be - maintained between
temporary liquidity provision, on the one hand, and medium term oriented monetary policy,
on the other.
Should liquidity be provided at a penalty rate, as some have argued, to avoid moral hazard?
The answer is clearly positive if and when liquidity assistance is targeted at specific
institutions. But there is no reason, for Central Banks, to significantly depart from prevailing
policy rates if their main objective is to respond to an exogenous and general increase in
demand for central bank balances.
In the future, monetary policy may have to be adjusted, not for the purpose of easing
financial tensions, but according to its own objective and in view of the state of the economy.
As regards the euro area, the Governing Council has judged that, in the current uncertain
environment, it was appropriate to gather additional information before drawing conclusions
for monetary policy, although the overall stance is "still on the accommodative side" and...
"the medium-term outlook for price stability remains subject to upside risks".
Looking further ahead, difficulties in the subprime mortgage markets combined with the
generalized securitization of loans will lead to losses whose localization in the financial
system remains undetermined. This information problem is currently creating uncertainty and
turmoil. However, things should be put in perspective. Available data indicate that, unless the
economy unexpectedly deteriorates, those losses will remain small in comparison to total
available capital in the financial system and should be easily absorbed. Of course, conditions
remain fragile in many segments of the capital markets. Perverse dynamics may always
develop. By acting to restore balance and stability in the interbank market, Central banks are
just doing their job.