Information asymmetries When talking about information in the context of the financial turmoil, a key dimension of interest regards the role of informational asymmetries in the money markets (though I will often refer to the euro money market, it goes without saying that the issue of information asymmetries and adverse selection equally applies to money markets in other currency areas). Indeed, during the current turmoil widespread uncertainty about the distribution of exposures to sub-prime losses across financial institutions has led to the inability of distinguishing sound from unsound financial institutions, almost bringing inter-bank trading to a halt in August. The disruptions to inter-bank trading were compounded by banks’ uncertainty about their own liquidity needs reflecting various factors: (1) difficulties in tapping market funding sources (particularly the US dollar-denominated asset-backed commercial paper market), (2) larger than anticipated recourse by investment funds to committed credit lines, and (3) at least for some banks, uncertainty about the possible need to take over struggling off-balance sheet conduits and structured investment funds. Although the interventions by the ECB have since had a stabilising effect on the euro money market rate at the very short maturities and, more generally, this market has recovered some of the lost ground, lack of confidence among commercial banks continues to restrict trading activity and inflate counterparty risk premia (particularly in the unsecured term money market).
Of course, any such support policy, if anticipated, will be taken into account when banks establish their risk management frameworks for “tail” events. Still, one cannot generally conclude from this that central banks should not re-act and support the system in the case of severe tensions. To rigorously analyse moral hazard issues relating to financial crisis management by central banks, one first needs to distinguish between different but interrelated types of policy interventions. The reason for this is that the possible effects on incentives of different measures can be very diverse. However, this differentiation has often been missed when criticising central bank actions on the grounds of moral hazard considerations. 3  A. Giovannini and L. Spaventa (2007), “Subprime lessons: fix the information gap”, 5 November 2007, http://www.voxeu.org/index.php?q=node/690. BIS Review 143/2007  5  Let me distinguish briefly between four possible types of central bank measures: First, moral hazard issues have been raised in relation to the case in which the central bank lowers its key policy rate in response to financial turmoil. It has been argued that, if central banks lower interest rates at a time of market corrections and declining asset prices, economic agents may believe that the policy-makers are prepared to use monetary policy to support asset price valuations in order to prevent market downturns. If such belief becomes widespread, investors are likely to engage in excessive risk-taking behaviour, thereby sowing the seeds of future financial crises.