Self-regulation helps reduce moral hazard

Self-regulation has been much maligned, thinks John Kay of the FT in a thoughtful article in early December 2009 on government intervention in the financial crisis.

He thinks it bad because it distorts competition, increases moral hazard and disrupts private sector initiatives which might be better and less costly.

Oh, yes, and it’s very expensive.

Talking of the potential exaggeration of moral hazard (you want to be seen as in dire straits in order to trigger the bailout), he comments pithily:

“Too big to fail” is a powerful barrier to entry, because no newcomer to an industry begins by being too big to fail. The lending operations of banks are profitable once more – who couldn’t trade profitably if the government underpinned their liabilities? Pity Warren Buffett, whose debt is downgraded because his well-run insurance business remains in private hands while his principal competitor, the failed AIG, basks in the credit of the US Treasury.

His over-arching conclusion is that “the principal mechanism of risk control is self-regulation by the sector”, i.e. each party ensuring that its counterparty is someone with whom it is safe to do business.

The failure to exert proper diligence was the product of optimistic beliefs about what regulation and complex risk-control mechanisms could achieve, the nationalisation of many mechanisms of self-regulation, and the inappropriate delegation of regulatory responsibilities to rating agencies, combined with the hubris that is part of every era of financial folly. But instead of renewing these self-regulatory mechanisms, we have effectively abolished them. That will prove an expensive choice.