Leading article: Dodgy loans, banks and bail-outs

Friday 17 August 2007 00:00 BST
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Across the world, the financial trading screens turned red again yesterday as stock markets from Wall Street to Tokyo took a hammering. More than £100bn has been wiped off the value of the FTSE100 since last Wednesday. And there is more carnage to come. The inevitable downgrading of ratings on more credit instruments - as the American sub-prime mortgage market unravels - will create more dislocation in the credit markets. And this in turn will continue to undermine confidence in equities.

But however loud the scalded hedge-fund managers and bankers scream, it is vital that central bankers resist the pressure to push through interest rate cuts beyond very short-term injections of liquidity. Recession is not a serious prospect with the global economy growing at a healthy rate. Moreover, any free market needs the prospect of failure if it is to function properly. Those financial institutions that have left themselves overexposed on account of their imprudent borrowing or lending must be left to deal with the consequences. Cutting interest rates to inject confidence artificially into the system would make financial speculation a one-way bet.

Unwise investors and borrowers in the City and Wall Street have been bailed out too often in this way in the past by central banks. And unjustifiably low interest rates for an extended period of time have contributed to the present mess. Put simply, if you make money too cheap, people will get greedy and begin to make misjudgements. This is what has happened over the past five years.

But there are some wider lessons here, beyond the failures of monetary management by central banks. Regulatory failure is another important part of this story. As mortgage lenders, particularly in the US, come under pressure, it becomes increasingly clear that the performance of the credit rating agencies has been less than impressive. Too many dodgy loans were given a decent rating.

The new debt investment packages devised by the banks in recent years are also in need of serious scrutiny. The greater securitisation of debt (the selling on of debts by banks) has on the whole been a good thing. It has made global markets more liquid, something that has helped to deliver strong growth. But when no one knows who holds the ultimate liability (as has been the case with many of these complex debt instruments), it becomes a dangerously destabilising influence. The same is true of private equity deals. In many of these highly leveraged takeovers, it is far from clear who holds the risk if it all ends badly.

Such ignorance has made the present panic worse. Free markets need the risk of failure, but transparency is just as important.

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