Government guarantees on loans create ethical perils, report says

GOVERNMENT guarantees of bank creditors warp incentives and damage the “ethical foundations of capitalism”, according to a report out today.

State guarantees create a system in which “the poor pay taxes to keep the rich rich, regardless of how foolish or lazy the loans they have made might be”, said the influential think tank Policy Exchange.

Guarantees trigger a higher level of bonds in capital structures, lower liquidity ratios, and remuneration schemes that encourage greater risk taking, the report said.

Systems of lending at interest have always depended on bondholders and creditors being exposed to risk of loss, but government guarantees and bailouts have led to increasingly risky behaviour – in a form known as “moral hazard”, the report argues.

“Each bailout leads the bailout net to slacken, so that the next test of government willingness to bail out occurs at a higher level of danger,” said author Andrew Lilico.

Lilico recommends a new administration regime for banks that would see bondholders responsible for losses through a so called “bail in” system of debt-for-equity swaps.

Bailouts in the Eurozone are “fundamentally a continuation of the banking crisis”, and reflect the ongoing inability to deal with failing banking institutions, Lilico said. Credible mechanisms to resolve insolvent banks could have prevented the Irish and Greek bailouts, and may be required to save the euro, he added.