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Central banks’ hazards

• Robert Peston
• 15 Aug 07, 09:30 AM

The oldest dilemma for regulators is how to prevent their actions in protecting the integrity of the financial system from affecting the behaviour of those they regulate in the opposite ways to those intended.

It’s called “moral hazard”. The classic and legitimate fear is that regulators actually encourage banks and other financial players to take silly risks, by showing that they’ll always intervene to reduce the costs for the market of such imprudent behaviour.

Those concerns about moral hazard lay behind my uneasiness about how much cash the European Central Bank has been pumping into the banking system.

Of course, I understand that the ECB has a target for overnight interest rates. So in one sense it was rational for it to provide tens of billions of pounds of incremental short-term lending to Europe’s banks, to prevent that overnight rate from settling too far above its target of 4 per cent.

But the reason for the rise in those short-term interest rates was nervousness among lenders about which of them might be holding something very explosive and nasty in the frenzied game of pass-the-parcel of horrible financial risk – which stems ultimately from sub-prime lending in the US.

Or to put it another way, in providing all that cash or liquidity to the market, the ECB (and to a lesser extent, other central banks too) was bailing out banks – and, indirectly, hedge funds – who should have known better.

The danger inherent in the ECB bailing them out is that when this particular market storm is over, those banks and hedge funds will take on even greater risks and do even sillier and more opaque deals, safe in the knowledge that when it all goes wrong again – as it will – the ECB will always prevent drama turning into crisis.

On the other hand, there is a separate imperative for the ECB. There are growing signs of softness in the eurozone economy. And the sudden reduction in liquidity in the banking system and rise in short-term rates could have turned that softness into a more serious slowdown in economic growth.

It would have been unfair for Europe’s consumers and businesses to pay a big price in the form of slower growth in their income for the imprudence of those who lent to US homebuyers with poor credit histories.

Understandably, the ECB – and to a greater extent, Europe’s politicians – would want to avoid that.

Unfortunately, we are not out of the woods in terms of the impact on the real economic world from the financial mayhem. There’s a continued flight to quality going on, with the more marginal markets in Asia being hit hard overnight. That has prompted fresh falls in the larger, more liquid stock markets like London’s. Underlying all this is the continued reluctance of lenders to provide credit to all but the safest borrowers.

So eurozone consumers and businesses – and British ones – may yet pay a real economic price for the excesses of players in financial markets.

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