The bankruptcy of Bear Stearns would have been a good lesson

Why not let Bear bust?

The bailout of Bear Stearns seriously blunts market discipline as a force for market stability.

Market discipline is one of the three pillars of the Basel 2 accord and perhaps the most important.

It requires that financial institutions monitor their counterparties and discipline those which they perceive as being badly run or assuming too much risk.

Market discipline is based on the principle that market participants have a better understanding of what is happening than the supervisors.

When the investment bank faced immediate bankruptcy the Federal Reserve stepped in by underwriting $30bn worth of loans secured by some of the worst assets held by Bear Stearns. It also facilitated its sale to JP Morgan Chase at the initial princely sum of $2 a share.

Investment banks are far less regulated than commercial banks in the US. There is an implicit deal between financial institutions and regulators that those who get more Government protection are also more regulated, due to moral hazard, an arrangement that is eminently sensible.

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If the taxpayer is asked to provide insurance, the taxpayer should have a say in how those insured behave.

The Fed has now signalled an unprecedented willingness to underwrite the obligations of a lightly-regulated institution because it is considered too big to fail.

We are told that if Bear Stearns had been allowed to fail, the reverberations would have been felt throughout Wall Street, affecting profitability, possibly triggering another bank failure or even a full-blown crisis.

Unfortunately, the bailout of Bear Stearns means that counterparties and clients of other institutions will continue happily to do business with institutions they suspect are in difficulty, in the safe knowledge that the government will bail them out if things go bad.

Market discipline is going out of the window.

It is interesting to observe that with the Government money in hand, the value of Bear Stearns shares has risen sharply, JP Morgan Chase has already increased its bid to $10, and the eventual takeover price may even be higher.

At the same time the value of the Government backing remains $30 billion. It would have been more sensible if bidding for Bear Stearns reduced the value of the Government aid, rather than increase the takeover price, thus protecting the taxpayers' interests and not the shareholders' interests.

The bailout of Bear Stearns is part of a common trend whereby financial institutions, having assumed too much risk, look towards the government to save them from their own mistakes.

This has happened in every financial crisis, whose eventual cost has depended on politicians' ability to withstand such demands.

A typical banking crisis costs about 10pc of GDP according to a recent World Bank study.

Eight per cent of the costs flow from inappropriate government response, such as open-ended bailouts, and only 2pc from the actual crisis. The eventual costs of the current sub-prime crisis are following this pattern.

There is enormous pressure on the world's central banks to provide liquidity, either by lending to banks, or reducing interest rates.

The justification being offered is that nobody else wants to lend money to the banks except at a very high rate which destabilises the financial system. The fact that the liquidity squeeze is a problem of the banks own making seems to be forgotten.

It is instructive to look beyond the headlines and ask oneself why nobody except the central banks wants to provide liquidity.

The reason is that the banks have made their operations so complicated that only a handful of people understand what is going on, with enormous scope for misrepresenting the value and the risk of assets.

While this complexity has been very profitable in the past, it implies that it is hopelessly beyond the ability of the world's regulators and most counterparties to understand what the banks are up to.

This complexity minimizes both regulatory scrutiny and market discipline. The complexity that used to be a virtue is now a vice.

By bailing out Bear Stearns, the Fed is rewarding bad behaviour.

The shareholders of Bear Stearns may have lost substantial amounts, but the counterparties are left untouched. The stability of the financial system depends on market discipline, and counterparties being wary. The Fed actions make them too comfortable.

The provision of liquidity is a subsidy to the banks at the expense of taxpayers, causing long-term economic damage. The increase of liquidity is inflationary, and increasing inflation in the middle of an economic downturn risks the re-occurrence of the dreadful 1970s' stagflation.

The costs of reducing the 1970s inflation were enormous, much higher than any short-term benefit provided by liquidity injections.

On both sides of the Atlantic there is a debate between those who would like to regulate the financial system further and those want to leave it as it is now.

In recent years the regulators have shown that their understanding of the financial system, and especially in the complex products sold by banks, is very limited.

I doubt the regulators' ability to create an effective system, regulating banks more heavily and increasing financial stability, without stifling innovation or getting unnecessarily in the banks' way.

If the government is both the ultimate guarantor of the banks, and the supervisor of their risk systems why does the government not get to share in the upside? Why don't we simply nationalise the banks?

To avoid such drastic measures, we need to make banks more sensitive to risk. We need more market discipline.

To that end the bankruptcy of Bear Stearns would have been a good lesson.