Moral hazard is one of those concepts, beloved of classical economists, which works well in the text book, but less well in reality.
The 10th anniversary of Northern Rock reminds us why that is.
Moral hazard arises when the existence of insurance causes people or businesses to take on greater risks or act more recklessly than they would do without it.
The protection for bank deposits in place when Northern Rock failed was designed with that principle in mind.
Savers had skin in the game because FSCS protected all of only the first £2,000 and then 90% of the next £33,000.
In principle – and I stress, in principle – this should have caused savers to have regard to the safety of banks or building societies when deciding where to save.
There is also a corollary: namely, that the authorities should have been willing to see savers in a failed bank lose any money not covered by deposit protection.
The practice, however, is different.
For one thing, most people are simply unaware that different banks, building societies are credit unions present differing levels of risk. Other than in periods of stress, they assume all are safe.
You certainly cannot expect most savers to do due diligence on high street deposit-takers. After all, few experts appreciated the risk inherent in the Northern Rock business model before it materialised. What hope for non-experts?
For another, the consequences of a run on a bank – and the loss of confidence that goes with it – are a much bigger threat to financial stability than insulating savers from moral hazard.
Panic is contagious. It is a real and present danger – or was in 2007. Moral hazard is, at best, a theoretical risk.
All this explains why deposit protection – and the role of FSCS – has undergone marked changes since 2007.
The most obvious is the change in the scope of deposit protection itself. FSCS now protects in full the first £85,000 of a deposit. In effect, that protects around 98% of all savers.
More generous deposit protection is, however, a necessary but not sufficient condition for financial stability.
FSCS must also be able to make good its protection promise if called on. And that protection promise – and confidence in FSCS’ ability to deliver – must be widely known and understood.
FSCS also fulfils both of these other conditions and has done for some time.
If called on by the Bank of England, we have been able since 2011 to pay-out the great majority of depositors in a failed bank, building society or credit union in seven days. We do so automatically thanks to the single customer view files maintained by all banks, building societies and credit unions. Savers even don’t have to complete an application.
This matters because most people run their lives from their current account and rely on access to the funds it contains. They need to know not only that their money is safe, but also that it’s accessible. That’s what seven day pay-out ensures.
This is a promise FSCS keeps on a regular basis. For example, this month we compensated savers in the Staffordshire Credit Union. Most received in well under seven days either a cheque in the post or a letter which can be cashed at a local post office.
We have also done much in partnership with banks, building societies and credit unions to raise awareness of this protection. After all, you can’t be reassured by an unknown quantity.
And FSCS protection was an unknown quantity at the time of the financial crisis.
No longer: around three-quarters of adults now know about our protection and are reassured by that knowledge.
So, yes, moral hazard remains an important consideration for anyone designing an insurance arrangement. But, when it comes to financial stability in a crisis, the certainty of effective deposit protection is in practice more important.