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What Is Moral Hazard And How Was It Invoked in the UK During the Northern Rock Crisis in 2007?

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Written by: Otakar Hájek

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This paper was submitted as a research essay at King's College London towards the author's LL.M degree in 2008.

1. Introduction

The problem of "moral hazard" originally comes from the area of insurance. The insurance industry became aware some time ago that ownership of insurance increases the risk that insured parties will incur losses: holding insurance tends to dull the incentive for insured parties to take action to help prevent losses.[1]Some definitions of the term still prefer to describe moral hazard using the insurance terminology, which may lead to a false impression that this phenomenon is solely confined to insurance.[2]

However, it is now generally accepted that moral hazard is not merely an insurance problem, but that it can be found in a number of different situations, in which, for various reasons, economic agents do not have to bear the marginal costs of their actions. These economic agents may range from governments taking advantage of the IMF's default-staving safety net, the mere existence of which induces them to borrow irresponsibly, to reckless exploitation of public healthcare or social security systems by some individuals. It is therefore submitted that the term "moral hazard" should be defined in a much broader way in order to encapsulate the multitude of circumstances in which it may be invoked.

In the context of the aforementioned, it may thus be helpful to describe moral hazard as a situation in which the existence of a potential rescuer a creates itself the need for rescues to occur.[3]In other words, moral hazard arises when people behave recklessly because they know they will be saved if things go wrong.[4] An equally relevant definition describes moral hazard as a term based on the principle that if actors are allowed to escape the consequences of their risky actions, they are more likely to engage in reckless behavior in the future.[5] It is therefore possible to conclude that adverse incentives may be created as an unwanted by-product of safety nets of any kind and form, not necessarily connected with the existence of insurance.

One of the fields in which the problem of moral hazard has been identified and discussed is commercial banking. The current practice in the

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industry includes several features that are capable of creating incentives for various participants to behave irresponsibly. The aim of this work is to identify these features and to evaluate their significance using the example of the Northern Rock Crisis of 2007. The author will also refer to the IPB Crisis 2000[6] and its aftermath, partly due to the notable parallels between these two crises, and partly in order to emphasize the potential significance of the subsequent arbitral award[7] in defining the limits of discretion of the State in providing State aid to banks in trouble.

2. Moral Hazard in Banking

Modern banking systems contain a number of elements capable of invoking moral hazard behaviour in their participants. Banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders' funds in institutions deemed too big or too politically sensitive to fall.[8] In order to maximize their profits, banks may consequently be tempted to engage in riskier investment strategies than they would dare to venture in the absence of such guarantees. It is also submitted that, as a result of these incentives, banks are willing to increase shareholder wealth by widening the distribution of returns on their portfolio beyond that which they would choose in an unprotected environment.[9] Bank shareholders, whose liability is limited to the value of their shares, are generally happy to endorse such conduct as it increases the income that they receive from their shares. The temptation facing bonus-earning managers to engage in risky activities is also obvious, especially when they are protected from the consequences of failure, e.g. by guaranteed severance payments. Likewise, the depositors make use of the safety nets to maximize their returns. As a result, the interest rate on deposits becomes the most important, if not the only criterion considered in their decision to make a deposit with a particular bank while the credit/insolvency risk of the chosen financial institution is usually neglected as unimportant or irrelevant.

In the modern banking world, a further, distinct and very important type of moral hazard has emerged. It is the moral hazard, which results from asymmetric information between banks and their lenders. This information asymmetry has been significantly increased by the inherent complexity of modern financial products. Banks issue securities with attractive nominal interest rates, which are often backed by sophisticated portfolios containing good and bad assets, the true risk of which cannot easily be assessed by the investors. It is argued that in the current crisis, even the private rating agencies dramatically underestimated the risks involved, which helped lure international financial investors into purchasing mortgage-backed securities at exaggerated prices.[10] In this environment, banks are naturally induced to sell "lemon bonds", and to use the proceeds to finance further risky lending.

The principal problem with the various instruments of risk redistribution described in the preceding paragraphs is that the costs of their  operation are not fully (and sometimes not even partly) borne by those who benefit from them. It is the taxpayers who ultimately pay in return for a variety of safety nets and state-sponsored insurance schemes. Taxes can therefore, in this context, be described as insurance premiums paid by the citizenry, hopefully in return for increased stability of the financial  system in general. Furthermore, reallocation of risk distorts the incentives of market participants to behave in an economically efficient manner. By protecting private investors, creditors, as well as financial institutions themselves from the outcome of their errors and misjudgements, moral hazard undermines the concept of liability.

Such mass production of moral hazard obviously requires a proper justification. The usual explanation is that banks provide an important public utility: a safe haven for money, for storing its value, and a payment system. The generally recognized susceptibility of the banking system to contagion that is capable of affecting the whole economy and the consequent necessity to minimize systemic risk is also an important reason for the decision to spend public funds on maintaining stability of the system.

It can be argued that most people prefer to incur the cost of moral hazard. They seem to accept it as a sort of insurance premium, the price of which is perceived as reasonable taking into account the gravity of the risks it should prevent. However, it is submitted that the wide acceptance of moral hazard is merely a result of an intuitive political consensus that these instruments are necessary and inherently connected with the business. It is also submitted that such consensus may be enhanced by various techniques, which are designed to mitigate political opposition against public expenditures of this kind.

John Hoefle, referring to the situation in the United States, points out that "[m]ajor financial crises are never announced in the newspapers but are instead treated as a form of national security secret, so that various bailouts and market-manipulation activities can be performed behind the scenes."[11] In this respect he contrasts the position of the Federal Reserve, a private corporation answerable to the private banks that are its real owners, and the Bank of England, which is actually owned by the British Government. Measures of the latter institution therefore must be given greater publicity and issues of political accountability need to be considered more carefully in this context, than is the case in the United States. This problem has been clearly demonstrated also in the Northern Rock crisis.

Another way of suppressing objections against the expensive safety network is to make the price that is paid less conspicuous. Rather than taxing other banks or the taxpayers at large, central banks as lenders of last resort may impose an indirect tax in the form of inflation, i.e. by creating new money out of nothing with accounting entries. Adding new money to the
economy without adding new goods or services, however, is not without cost. It shifts the cost to the public, driving prices up for the consumers.[12]

The aforementioned techniques create an environment in which the notion of who bears the costs of what is considerably blurred. Besides, it seems to be impossible to present any credible risk-benefit analysis of the moral hazard problem as no one really knows how to measure, quantify it or how to describe its effects by means of an acceptable mathematical model. This leads to endless theoretical debates as well as empirical studies, which often reach opposite conclusions. Opinions on what level of moral hazard is inevitable for proper functioning of the financial sector thus differ considerably. Some authors conclude that moral hazard in banking is essentially no different from moral hazard in insurance, that it is clearly an undesirable phenomenon, and that

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the best way to deal with it is to leave the costs of any protection measures to the parties affected without interference from governments.[13] Another group of authors also recognize the dangers of moral hazard, but, contrary to the laissez faire approach, they suggest that effective regulation and supervision should play a key role in keeping it within proper limits.[14] However, there are also powerful voices arguing that "[m]oral hazard fundamentalists misunderstand the insurance analogy, fail to recognize the special features of public actions to maintain confidence in the financial sector and conflate what are in fact quite different policy issues. As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability."[15]

Representatives of all three groups mentioned in the previous paragraph are usually able to present strong arguments in support of their respective cases. It is hard not to agree in principle with the proponents of the laissez faire approach, insisting that banks should be treated like any other firm in any other industry. If banks cannot meet their contractual obligations they should be required to "go under" and liquidate. This seems to be a perfectly fair solution. However, leaving aside the obvious dangers of systemic risk, which might adversely affect even persons who have never had anything to do with the particular bank in trouble, introduction of such policies may also be perceived as an undue penalty both for the depositors and the banks' shareholders who have deposited or invested their money under fundamentally different rules. None of these results can be described as particularly fair. One can also have understandable sympathy for the proposition that bank runs are necessary in order to keep the banking system under check and to prevent inflation.[16] However, it is equally necessary to consider whether the benefit of the purgative effect of bank runs outweighs the cost of the general loss of confidence in the banking system.

Opponents of state intervention for the purposes of reduction of moral hazard also often argue that, given the uncertain effectiveness of such interventions, the most imporant factor inducing financial institutions not to succumb to moral hazard temptations is the banks' franchise value, i.e. a stream of earnings with a positive net expected value.[17] Provided franchise value is sufficiently great, then shareholders should have an incentive to avoid liquidation by maintaining adequate capital in the bank and reducing the riskiness of bank assets. In the opinion of some authors, franchise value plays a crucial role in suppressing moral hazard. It has been argued that, assuming some degree of effective regulatory audit, it is only when franchise value is extremely low that the incentive to protect franchise value is eroded by the desire to exploit moral hazard.[18] However, it is necessary to keep in mind that while it is relatively easy to admit that the notion of "franchise value" can have some effect on banks' behaviour, a clear and generally accepted conclusion as to its practical importance has not been reached. The concept of franchise value itself is extremely difficult to quantify, and any suggestions as to its influence on shareholders' behaviour are thus necessarily even more speculative.

The proponents of using tighter regulation as a means of suppressing moral hazard in banking can be equally convincing in arguing their case. As a result of an analysis of balance-sheet data of various financial institutions, Grossman came to the conclusion that insured institutions operating under relatively permissive regulatory regimes were more prone to undertake risky lending activities than their tightly regulated counterparts.[19] Regulation also seems to be the only effective means of ensuring higher transparency of modern financial products especially in terms of assessment of their riskiness. However, one of the most recent and comprehensive empirical studies dealing with the effectiveness of regulation in banking shows that giving official supervisors greater powers has never enhanced bank operations or reduced bank fragility.[20] By way of  comparison of various regulatory systems the study indicates that regulatory actions tend to lower bank development, induce less efficient banks, exacerbate corruption in bank lending, and intensify banking system fragility. Nevertheless, the authors of the study recognize that bank regulations and supervisory practices that force banks to disclose accurate information to the public generally tend to have a positive effect. Based on the aforementioned, it thus seems advisable to have only a limited confidence in the ability of regulation to deal with moral hazard. 

In practice, governments use a variety of regulatory measures in order to reduce banks' incentives to take excessive risks. These involve imposition of capital adequacy ratios, rules on risk management and sometimes also liquidity requirements. As indicated above, the effectiveness of such measures is often questionable. It has been argued, for example,  that an increase in capital adequacy requirements will only have a short term impact, leading to an immediate increase in risk aversion and hence a reduction in bank lending. However, once the banks manage to replenish their capital, the changes in capital requirements cease to have any impact on incentives for risk-taking.[21] Other authors go even further claiming  that the introduction of regulatory capital requirements indeed induces banks to shift their portfolio composition towards riskier assets, as they wish to retain their profitability even if the amount of capital that they are required to set aside increases.[22] It is therefore possible to conclude that regulatory reforms can alter preferences and risk appetite of market participants, but they accomplish this task through very crude and often exploitable tactics. Their precise impact on reduction of moral hazard in banking is to a large extent unpredictable.

Given the unsatisfactory, or at least uncertain effectiveness of regulation in terms of suppression of moral hazard, attempts have been made to find alternative solutions by eliminating adverse incentives in the banking industry. Especially the notion of narrow banking has been repeatedly put forward as an alternative.[23] Since we cannot be sure of our ability to prevent banks from acting upon their natural moral hazard incentives, the idea behind the concept is to transform these incentives themselves. Much of the moral hazard problem exists because banks can invest in more or less anything with depositor cash. Given the extensive safety nets, they thus prefer to invest in riskier asssets in order to obtain higher returns. An effective way to eliminate the problem might therefore be to require banks to invest depositor wealth only in safe assets, especially into money market mutual funds with limited investment possibilities largely confined to government securities and commercial papers. Banks acting in this way are generally described as "narrow banks". Other entities, referred to as finance houses or non-bank financial institutions, must then arise to invest in risky projects. As these institutions will raise their capital on domestic and international financial markets, their shareholders and other sophisticated suppliers of capital will have the right incentives to monitor them, so there should be no need for intrusive supervision of

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state authorities. They would be essentially unregulated and allowed to go under.[24] Under such regime, these institutions would be motivated to capitalise themselves better and not to gamble with depositor wealth. Narrow banks, on the other hand, would remain able to provide the necessary liquidity, while the moral hazard problem as well as the chance that a financial crisis could wipe out peoples' savings would be considerably reduced.

However simple and effective the narrow banking solution may seem, there are numerous arguments which undermine its viability. It has been argued that the pool of safe assets is too small to back narrow banks, so that they would find it difficult to invest deposits. It has also been submitted that the world pool of liquid savings to invest is too small to support the non-bank financial institutions. Speculative as these arguments may be, they should not be rejected in a cavalier fashion without proper analysis of the problem.[25] It has also been pointed out that providing liquidity and credit are actually one function, the performance of which by two different types of financial institutions is certainly not an optimal solution.[26] Just as with deposits, customers can in many cases withdraw their credit on demand, and the occasions on which credit is withdrawn are random from the banks' perspective. In order to fulfill its obligations to honor either deposit withdrawals or loan commitments, the bank must carry liquid assets, which have an opportunity cost of low returns. It is therefore argued that, if depositor and borrower demands for liquidity are not perfectly correlated, wide banks enjoying a natural economy of scope demand a relatively smaller pool of costly liquid assets and thus are more efficient. Another study on narrow banking comes to the conclusion that non-bank financial institutions tend to suffer from high agency costs and provide a less stable supply of credit relative to deposit-insured banks.[27] Should the deposit insurance subsidy be removed, the overall supply of lending would become even more fragile. Therefore, if we want to achieve a stable credit supply and, at the same time, escape from the moral hazard dilemma, Miles concludes that narrow banking does not seem to provide a satisfactory solution. Given the complexity of the issues outlined above, it is submitted that it is by no means clear whether narrow banking could by itself provide an adequate answer for all the problems that it should ideally solve.

Authors claiming that the price paid by the public as a result of moral hazard is a prudent expenditure considering the gravity of the systemic risks which would otherwise arise in the absence of extensive safety nets often use the convincing argument that much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. It is argued that a competent lender of last resort who lends freely at a penalty rate against good collateral actually turns a profit.[28] Nevertheless, the fact remains that such facilities are only used in situations, where the borrower would have otherwise been unable to obtain the necessary funds on the market. If a  borrower in trouble can count on such a form of aid, a powerful incentive for irresponsible behaviour is inevitably created. It is therefore submitted that even if an increase in moral hazard does not necessarily have to make the taxpayer subject to any additional costs in every particular instance, the mere fact that it was increased makes it more likely that it will take its toll in the future. Again, the principal problem is that it is very hard to illustrate these dangers by means of exact figures.

Since it is difficult (if not impossible) to objectively quantify the relative value or importance of the conflicting objectives and solutions outlined above, most of the relevant writings remain confined to little more than persuasive rhetorical exercises. Striking the right balance between these objectives and solutions thus seems to be largely a result of an intuitive process, an art form rather than an exact science. Saying that, however, it would be unwise not to take appropriate lessons from crises that have

already happened in the past. In the end, it is only empirical experience (however painful it may be) combined with thorough analysis of the relevant issues, which can lead us to a solution, which is as close to the optimal one as possible. The Northern Rock crisis and its aftermath obviously provide a considerable amount of food for thought in this respect.

3. Northern Rock Crisis and its Moral Hazard Implications

The Northern Rock crisis of September 2007 was definitely the most visible result of the liquidity crisis, which hit the financial sector in the UK as a consequence of the worldwide problems triggered by the collapse of the US sub-prime mortgage market. Funding problems of the country's eighth largest high street bank and fifth largest mortgage lender led to the first run on a British bank in more than a century. It is only natural that such an event has provoked extensive debate aimed predominantly at analysing the reasons for the crisis, allocating the blame, and on improving the regulatory framework as well as the procedures and policies of the relevant public bodies so that a similar crisis could be prevented or adequately handled in the future. One of the central topics of this debate was the general question of how to effectively maintain or restore confidence in the UK financial system without suffering any substantial increase in moral hazard. The second question was whether or to what extent the relevant authorities managed to achieve this goal in this case.

The first point to make here is that under the then current regulatory regime Northern Rock was allowed to develop a business model, where funding of long term mortgage debt relied substantially on short-term loans obtained on wholesale markets rather than on retail deposits. This meant that it did not have to maintain extensive and costly branch networks and could therefore boast of the lowest cost-to-income ratio in the banking sector, extremely rapid growth rate, and at the same time distribute generous dividends to its shareholders. Futhermore, it was not required to maintain any liquidity insurance, which would have otherwise provided a safeguard for the times when wholesale lenders would no longer be willing to lend. The difficulty was that this model was dependent on a continuous flow of funds through the inter-bank and wholesale markets.[29]

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However, this flow has been seriously disrupted as a result of the global credit crunch of summer 2007, and Northern Rock consequently became unable to obtain funds to run its day-to-day operations. At the same time, due to the fears triggered by the sub-prime mortgage crisis, Northern Rock could no longer effectively use securitisation schemes in order to generate cash and unload risk by parcelling its home loans as bonds and selling them to willing investors, as it did in the past.

It is necessary to emphasize that Northern Rock's business model was quite a unique structure. All other banks rely heavily on retail deposits. No other UK bank appears to have conducted business in the same way as Northern Rock.[30] It was argued that Northern Rock was barely a bank at all and that it rather resembled a gigantic SIV. Like a structured investment vehicle, Northern Rock issued cheap debt to fund longer lending for higher yields. While SIVs invested in US sub-prime securities, Northern Rock sold mortgages. And, as with SIVs, when investors fled the markets the Rock struggled to refinance its debt as loans matured.[31] The fact that it was the only significant UK bank whose financing imploded during the crisis demonstrates that its problems were specific and home-grown, not generic and so the fault of others.[32]

The real trouble started on 13 September 2007, when it was revealed that Northern Rock had asked for and been granted emergency financial support from the Bank of England, in the latter's role as lender of last resort.[33] Despite the bank's and the relevant authorities' assurances that the bank was solvent and that there was no reason to panic, customers began to queue in front of the bank's branches in order to withdraw their deposits. In the following three days the bank had to pay its depositors more than L 2 bn of their money - about 8% of Northern Rock's total deposits.[34] At the same time, share prices of Northern Rock and of other mortgage banks in the UK saw a dramatic downfall. It was only thereafter that Chancellor Alastair Darling intervened by making a statement that the Treasury would guarantee all of the deposit liabilities of Northern Rock and that the same facilities would be made available to other similar banks in difficulty in the UK. This move has effectively stopped the run on the bank and has led to a significant recovery of the share prices of the relevant financial institutions. What it has not stopped, however, were questions, comments and criticisms focused on the way the crisis was handled.

It is necessary to emphasize that, facing the general credit crisis, the Bank of England refused to inject liquidity into the banking system, as other central banks[35] have done, because doing so would encourage banks to go on taking excessive risk.[36] Instead it chose to make funds available to individual institutions in trouble, through its emergency loan facility. Under the traditional lender-of-last-resort rules, the central bank should support solvent but illiquid institutions provided that there is full collateral and a penal rate of interest is charged to act as a disincentive for use and reliance.[37] It is argued that this was exactly what the Bank has done in the case of Northern Rock. Nevertheless, the fact remains that, for various reasons, such a measure proved insufficient to prevent general panic resulting in the bank run and that it had to be reinforced by an extensive ad hoc public guarantee of deposits. Of course, the adverse effect of such guarantee on the level of moral hazard in banking may be considerable.

Ironically enough, the liquidity support facility designed to help the bank overcome its temporary liquidity problems acted as the immediate trigger of the run. The information occupied most of the national newspaper's headlines and it can be argued that it was precisely the unnecessary publicity that induced people into massive scale withdrawals. Although the Governor of the Bank of England Mervyn King argued that he was statutorily prevented from providing financial support for Northern Rock in secret, commentators often disagree pointing out that undercover support was provided by the European Central Bank in the past without raising any such issues.[38] It is submitted that it would be very useful to examine the possibilities of providing similar forms of public aid in a much more discrete manner in the future.

It was also clearly shown that the deposit insurance scheme in effect at the time of the crisis was insufficient to keep depositors calm in times of major market disturbances and was thus unable to contribute to greater  stability of the system. The amount covered was too low, the deductible for deposits over Ł 2000 was an invitation to run, and the time (allegedgly up to 6 months) it could take for depositors to get their money back was far too long.[39] No wonder that a new scheme was announced very soon after the crisis, whereby the insurance cover was expanded to guarantee 100% of the first Ł 35,000 of savings. It is generally perceived that the risk of increase in moral hazard resulting from the more generous insurance scheme is worth taking if such insurance is capable to achieve what is expected. However, the efficiency of the new system will also depend on the speed at which the compensation will actually reach the affected depositors. If reimbursement takes too long, many depositors may still hoose to withdraw their funds immediately rather than wait for the compensation. Should this be the case, an ad hoc public guarantee of deposits may still be the only way to maintain financial stability in the future. Another principal question raised was how to maintain liquidity in the markets in times of crises without increasing moral hazard, and whether the Bank of England should act not only as the lender of last resort, but also as the market maker of last resort correcting market failures by providing liquidity to the markets. Buiter suggests that liquidity problems may be solved by changing the restrictive liquidity policy of the Bank of England.[40] In his view, the Bank should give more support to illiquid markets in general by widening the range of acceptable collaterals, which could be used by the banks in liquidity-oriented open market operations. Such collateral would include illiquid instruments such as mortgages and asset-backed securities. Provided this collateral is priced severely or even punitively, and has a further 'haircut' or discount applied to it, there will be no moral hazard and the Bank can expect not to lose money. Furthermore, such liquidity facilities could be provided at longer maturities, provided that the interest rates would reflect liquidity risk premiums as well as default risk premiums. Market failures would thus be corrected without creating additional moral hazard.

However, most commentators seem to agree that the problems of Northern Rock were so serious that no general loosening of the liquidity policy would have saved it.[41] Consequently, a one-off emergency loan would have been necessary in any event. The only other option would be to treat Northern Rock, which only accounts for 2 or 3 percent of the assets of UK-registered banks, as not being systemically important, and to let it go under.

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However, while it was undisputed that Northern Rock was not one of the biggest players on the market, it became equally apparent that its failure could easily trigger a more general credibility crisis. The immediate fall in share prices of other important mortgage lenders in the UK such as Alliance & Leicester and Bradford and Bingley clearly indicated the general distrust of investors in similar institutions and revealed the inherent fragility of the banking system. There was a justifiable fear that people would start to think that if Northern Rock could be allowed to go under, perhaps others would also be allowed. The announcement of a public guarantee of all deposits was therefore largely driven by the need to avoid the danger of similar withdrawals being made at other mortgage lenders, rather than by the desire to save Northern Rock per se. The effect of this move may nevertheless be considered to have substantially increased the dangers of moral hazard the next time any bank gets into difficulty, with the general public assuming that the Treasury itself (and not just the Bank of England) will step in to support their deposit liabilities.[42]

Assuming that the adoption of a more generous liquidity policy together with a more generous deposit insurance scheme would not be enough to keep Northern Rock afloat, and taking into account the fact that problems of this relatively small financial institution may seriously destabilise the whole system, the only viable solution for the future seems to be carefully designed regulatory reform. Such reform would have to be focused on detailed monitoring of liquidity of financial institutions and disclosure of their off-balance sheet and contingent liability exposures. Care must nevertheless be taken here not to overreact. Giving up Britain's light touch regulatory regime that attracts business to London might be a high price to pay for the increased stability of the system. Given these conflicting objectives, any large-scale legislative intervention seems to be too dangerous. The core of the reform should therefore probably lie in changing the supervisory practices and procedures of the Financial Services Authority and other relevant bodies so that these would be able to identify risky business models like the Northern Rock's in a timely fashion and deal with the problems before it is too late. Appropriate preventive measures would probably also have a considerable anti-moral-hazard effect.

The analysis of the moral hazard implications of the Northern Rock crisis would not be complete without discussing the problem of creating the right incentives for shareholders and management of financial institutions not to engage in excessively risky activities and to develop healthy business models instead. After all, it was their reckless dash for growth that was the ultimate reason for the crisis. A speedy imposition of public administration over mismanaged banks is sometimes presented as an effective way of dealing with the problem.[43] Once the bank is under public control, a long-term plan for it may be worked out, or its business may be sold off, in whole or in part. In such scenario, shareholders would be wiped out and would only be entitled to the proceeds of the sale after the bank's other creditors are satisfied. Day-to-day operations of the bank would no longer be carried out by its management, but by specially appointed public officials, who would give general priority to public interests over the interests of shareholders. Shareholders would thus be effectively punished for their irresponsibility. However, what remains questionable is whether the threat of losing their jobs combined with the threat of litigation for breach of directors' duties would constitute strong enough incentives to persuade bonus-oriented management to behave more reasonably. In this respect it is worth reminding that Northern Rock shareholders as well as its chief executive managed to retain their powers for many months after the run, which cannot be seen as a satisfactory result.

4. IPB Crisis and its Aftermath

Many aspects of the IPB crisis, which hit the Czech financial sector in the year 2000, were very different from the Northern Rock affair. Being the third largest bank in the country with millions of retail depositors, it is beyond any question that IPB was systemically important for the Czech economy.[44] Unlike Northern Rock, whose problems originated mainly from reckless borrowing, IPB's difficulties resulted from a bad (non-performing) loan book, most of which was created in the post-revolutionary euphoria of the early nineties by its risk-prone and probably sometimes also corrupt management. Contrary to the situation at Northern Rock, after the commencement of the run, IPB was immediately taken under public administration and its whole business was subsequently sold off to another Czech bank, CSOB.

However, as far as the moral hazard implications of these two crises are concerned, it is possible to recognize astonishing similarities. As with Northern Rock, the run was escalated by the enormous attention of the media, and by the fact that the deposit insurance scheme was inadequate. Similarly to the UK system, deposits were covered only up to 90%, and up to a relatively low threshold amount, and payments were considerably delayed.[45] The depositors' incentives for queuing in front of IPB's branch offices to withdraw their money were therefore identical. The harmful effect of the unnecessary publicity was recognized inter alia in the subsequent arbitration, where the tribunal referred to "the Czech Government's unjustifiable and unreasonable conduct regarding the circulation of negative information about IPB during the week before the second run on IPB that led to its failure."[46] Another striking parallel can be found in the fact that the Czech government waited for three whole days of the run before it issued a 100% guarantee of customers' deposits.

This is, however, where the parallels end. Simultaneous to the issue of the state guarantee of deposits, a public administrator was appointed to run the bank. From that moment onwards, neither the management, nor the shareholders had any say in IPB's operations. The public administrator then sold the bank's business to CSOB, whereas the whole transaction was effected over the weekend and under very suspicious circumstances. The core of the problem lies in the fact that the state issued a guarantee to CSOB for the value of all bad loans, which CSOB purchased as a part of IPB's business. The Parliamentary Investigation Committee was thus able to reach the conclusion that "CSOB has acquired the ownership of IPB completely "purified" by the state. It is not possible to say otherwise than as a gift."[47] The gift to CSOB obviously had to be paid for by the taxpayers. This gave rise to numerous disputes and investigations, some of which are still pending. However, from the moral hazard perspective, it is clear that such move has given a powerful warning to shareholders and possibly also to management of other potentially irresponsible financial institutions. On the other hand, the unpredictable and inconsistent conduct of the Czech Government in relation to the question of provision of state aid to banks in trouble has raised justifiable concerns resulting in the delivery of a controversial, yet very important, arbitral award.

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5. Conclusion - The Partial Award in Saluka Investments BV (The Netherlands) v. The Czech Republic and its Moral Hazard Implications

Although many of the aspects of the IPB crisis have not yet been resolved, the contentious issues of the involvement of the Czech state in the crisis have already been carefully dealt with not only by the Parliamentary Investigation Committee, but also, and perhaps more importantly, by the arbitral tribunal in the investment arbitration of Saluka Investments BV (The Netherlands) v. The Czech Republic. In its partial award, the tribunal held that the Czech state failed to negotiate with IPB's shareholders (Saluka) in good faith about providing state aid, and that it was "obliged to provide financial assistance to firms or industries in a way that does not amount to an unfair or inequitable treatment of a foreign investor."[48] Based on the provisions of s. 3 (1) and (2) of the relevant bilateral investment treaty,[49] the tribunal summarized the limits for exercising the Czech state's discretion in relation to providing public aid to troubled banks as follows:
"The Respondent has violated the "fair and equitable treatment" obligation by responding to the bad debt problem in the Czech banking sector in a way which accorded IPB differential treatment without a reasonable justification. The Big Four banks[50] were in a comparable position regarding the bad debt problem. Nevertheless, the Czech Republic excluded IPB from the provisioning of financial assistance. Only in the course of CSOB's acquisition of IPB's business during IPB's forced administration was considerable financial assistance from the Czech Government forthcoming. Nomura (and subsequently Saluka) was justified, however, in expecting that the Czech Republic would provide financial assistance in an even-handed and consistent manner so as to include rather than exclude IPB. That expectation was frustrated by the Respondent. The Tribunal finds that the Respondent has not offered a reasonable justification for IPB's differential treatment."[51]

It is therefore possible to say that, if other banks on the market are treated in a particular way, a bank can have legitimate expectations that it will be saved by the State in case of trouble and that, if such expectations are not met, this may amount to a failure to protect an investment of a foreign investor - the bank's shareholder. It is therefore submitted that the tribunal has unequivocally acknowledged the fact that moral hazard is an inherent feature of the banking industry, that banks who count on state aid in their risk planning behave perfectly sensibly, and that such "legitimate expectations" shall be adequately protected. Thus, in the light of the mentioned award, the decision to save Northern Rock might have created a dangerous precedent opening floodgates to future bail-outs by establishing the banks' right to state aid and the States' corresponding duty to provide such aid. Due to the size of Northern Rock it may be assumed that a similar form of aid should be made available in the future also to small banks, whose systemic importance is negligible. Furthermore, the award indicates that, in order to avoid possible liability for violation of investment protection laws, any government policies in this field should be not only effective, but also even-handed, consistent and transparent.


Mgr. Otakar Hájek graduated from the Law Faculty of Charles University in Prague in 2006 and completed his LL.M. degree at King's College London in 2008. After working as an in-house lawyer in a London hedge fund, he joined Allen & Overy in Prague in 2009. He is a corresponding member of the Editorial Board of the Common Law Review.


  1. Jackson, H.E., Kaplow, L., Shavell, S.M., Viscusi, W. K., Cope, D. Jackson, Kaplow, Shavell, Viscusi, and Cope's Analytical Methods for Lawyers. Foundation Press 2003, p. 50.
  2. Examples of such narrow definitions of moral hazard: "An insurance problem; when the cost of a disaster is reduced with insurance, people have less incentive to avoid the disaster." (, accessed on 4th June 2008); "Refers to the likelihood of a person or organisation willing to take on more risk as they are covered by insurance." (, accessed on 4th June 2008); "The possibility that a person may act dishonestly in an insurance transaction." (, accessed on 4th June 2008).
  3. Dalhuisen, J.H. Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law. Third Edition, Hart Publishing, 2007, p. 1113 and p. 1143.
  4. See (accessed on 4th June 2008).
  5. See (accessed on 4th June 2008).
  6. Run on the third largest bank in the Czech Republic resulting in imposition of forced administration over the bank and subsequent sale of the bank's business. The author was personally involved in some of the numerous disputes resulting from the crisis.
  7. Saluka Investments BV (The Netherlands) v. The Czech Republic, partial award, 17th March 2006.
  8. Wolf, M. Why banking is an accident waiting to happen Financial Times 27th November 2007.
  9. Milne, A., Whalley, A. E. Bank Capital Regulation and Incentives for Risk-Taking (December 2001). Cass Business School Research Paper Available at SSRN: or DOI: 10.2139/ssrn.299319 (accessed on 15th July 2008).
  10. Sinn, H. W. Wenn Banken mit Zitronen handeln Börsen Zeitung, no. 81, 26th April 2008, English version available at (accessed on 8th July 2008).
  11. Hoefle, J. The Federal Reserve vs. The United States Executive Intelligence Review 12th April, 2002.
  12. Brown, E. Bank Run or Stealth Bailout? Between Northern Rock and a Hard Place (, accessed on 4th June 2008)
  13. See e.g. Benston, G. J. Safety Nets and Moral Hazard in Banking. In Kuniho Sawamoto, Zenta Nakajima, and Hiroo Taguchi (eds). Financial Stability in a Changing Environment. Bank of Japan: 1995, pp. 329-377.
  14. See e.g. Grossman, R. S. Deposit Insurance, Regulation, and Moral Hazard in the Thrift Industry: Evidence from the 1930s [1992] 82(4) American Economic Review, pp. 800-821
  15. Summers, L. Beware Moral Hazard Fundamentalists Financial Times 23rd September 2007.
  16. Rothbard, M. Anatomy of the Bank Run, Free Market September 1985. Available at (accessed on 8th July 2008)
  17. Franchise value is also referred to as "growth opportunities" (Herring, R. and Vankudre, P. Growth Opportunities and Risk-Taking by Financial-Intermediaries. [1987] 42 Journal of Finance, pp. 583-599), and as "charter value" (Marcus, A.. Deregulation and Bank Financial Policy. [1984] 8 Journal of Banking and Finance, pp. 557-65).
  18. Milne, A., Whalley, A. E. , op. cit, note 9.
  19. Grossman, R. S., op. cit., note 14, pp. 800-821.
  20. Barth, J.R., Caprio, G. Jr., Levine, R. Rethinking Bank Regulation: Till Angels Govern. Cambridge University Press, 2006.
  21. Milne, A., Whalley, A. E. , op. cit, note 9.
  22. Koehn, M., Santomero, A. Regulation of Bank Capital and Portfolio Risk. [1980] 35 Journal of Finance, pp. 1235- 44l; Kim D., Santomero, A. Risk in Banking and Capital Regulation [1988] 43 Journal of Finance, pp. 1, 219-33; Sundaresan, N. Essays in Banking, Ph.D. diss. University of Massachusetts: 1996.
  23. Dalhuisen, J.H., op. cit., note 3, p. 1153.
  24. Dalhuisen, J.H., ibid.
  25. See e.g. James, K., R. The Case for Narrow Banking (, 8th July 2008); Rajan, R. Is There a Global Shortage of Fixed Assets? IMF speech, 1 December 2006.
  26. Kashyap, A., Rajan, R., Stein, J., 1999. Banks as Liquidity Providers: An Explanation for the Co-existence of Lending and Deposit-taking. National Bureau of Economic Research Working Paper 6962
  27. Miles, W. Can Narrow Banking Provide a Substitute for Depository Intermediaries? First Annual Missouri Economics Conference, May 4-5, 2001 (, accessed on 30th June 2008).
  28. Summers, L. Beware Moral Hazard Fundamentalists Financial Times, 23rd September 2007.
  29. Walker, G. Sub-Prime Loans, Inter-Bank Markets, Financial Support [2008] 29(1) Company Lawyer, pp. 22-25.
  30. Harcourt-Webster, A. Run on the Bank: Northern Crock, BBC Money Program. 9th November 2007 (, accessed on 8th July 2008)
  31. Farrell, S. Anatomy of a Credit Crisis The Independent, 6th November 2007 (, accessed on 8th July 2008).
  32. Wolf, M. The Big Lessons from Northern Rock Financial Times 15th November 2007.
  33. For a concise chronology of the crisis and its aftermath see e.g. "Timeline: Northern Rock Bank Crisis" (, accessed on 8th July 2008).
  34. Savers Return to Northern Rock, (, accessed on 8th July 2008).
  35. Most notably the European Central Bank and the Federal Reserve Bank.
  36. Prosser, D. The Fine Distinction between Lender of Last Resort and a Bail-Out The Independent 15th September 2007 (, accessed on 8th July 2008).
  37. Walker, G., op. cit, note 29, pp. 22-25.
  38. See e.g. Buiter, W. The Lessons from Northern Rock. Financial Times 13th November 2007.
  39. Buiter, W., ibid.
  40. Buiter, W., ibid.
  41. See e.g. Farrell, S., op. cit., note 31.
  42. Walker, G., op. cit, note 29, pp. 22-25.
  43. See eg. Buiter, W., op. cit., note 38.
  44. According to the studies of the Czech central bank, the collapse of IPB would have led to a serious endangering of the stability of the financial sector and to a decline in the growth of the GDP by 2 to 4%.
  45. For an overview of the numerous collapses of Czech banks an the operation of the Deposit Insurance Fund see e.g. "How the Banks Were Going Bust" (, accessed on 14th July 2008).
  46. Saluka Investments BV (The Netherlands) v. The Czech Republic, partial award, 17th March 2006, para. 504.
  47. Closing Report of the Investigation Committee of the Chamber of Deputies for the Clarification of the Decision Making of the State in IPB from the Time of its Establishment until the Imposition of Compulsory Administration and its Sale to CSOB, file no. VKPS-1/2000/500, p. 21.
  48. Saluka Investments BV (The Netherlands) v. The Czech Republic, partial award, 17th March 2006, para. 446.
  49. Agreement on Encouragement and Reciprocal Protection of Investments Between the Kingdom of The Netherlands and the Czech and Slovak Federal Republic, signed on 29 April 1991.
  50. i.e. IPB, CSOB, KB and CS.
  51. Saluka Investments BV (The Netherlands) v. The Czech Republic, partial award, 17th March 2006, para. 498.