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The war on moral hazards begins at home (John Kay, 26 January 2011, Financial Times)

The point of structural reform of the banking system is not to prevent banks from failing. Regulators have neither the technical competence nor political authority to achieve that objective. Nor, even if they had such competence and authority, would the outcome be desirable. The degree of supervision and control would undermine management responsibility. Regulators would need to be able to block Royal Bank of Scotland’s takeover of ABN Amro, halt Northern Rock’s expansion, and fire Dick Fuld and his associates from Lehman – and that just for starters. The banking system that would emerge would be like nationalisation, only not as fast-moving.

The purpose of structural reform is to allow financial institutions to fail without imposing large costs on taxpayers, retail customers and the global economy. The moral hazard problem is more subtle than sometimes suggested. Banks do not think: “We can afford to take big risks because the government will help if things go wrong.” The downside of failure for senior executives and boards is large even if it is not as large as it should be.

But senior executives and boards can reasonably think: “We can afford to run large counterparty exposures because the government will help if things go wrong.” Experience has shown that they will generally be right to think that. The transfer of wholesale market counterparty risk from the market to the taxpayer is the central issue. It distorts competition, allows excessive risk-taking and imposes wholly unacceptable burdens on the public. The most powerful mechanism for controlling risk-taking is prudential supervision, not by regulators, but by the market itself.