Question

Were there any ethical and/or moral issues in the banking and financial services industries prior to the 2007-2009 financial crisis?

Answer 1

Ans. The financial crisis of 2007 -2009 was the result of numerous market inefficiences, bad practices and a lack of transparency in the finncial sector. Market participants were engagging in behaviour that put the financial system on the brink of collapse. A moral issue exists when a person or entity engages in risk taking behaviour based on a set of expected outcomes where another person or entity bears the cost in the event of an unfavourable outcome. A simple example of a moral hazard is drivers relying on auto insurance. It is rational to assume that fully insured drivers take more risks compared to those without insurance because, in the event of an accident, insured drivers only bear a small portion of the full cost of a collision. Before the financial crisis, financial institutions' expected that regulating authorities would not allow them to fail due to the systemic risk that could spread to the rest of the economy. The institutions holding the loans that eventually contributed to the downfall were some of the largest and most important banks to businesss and consumers. There was the expectation that if a confluence of negative factors led to a crisis, the owners and mnagement of the financial institution would receive special protection or support from the government. Otherwise known as moral hazard. There was the presumption that some banks were so vital to the economy, they were considered "too big to fail". Given this assumption, stakeholders in the financial institutions were faced with a set of outcomes where they would not likely bear the full costs of the risks they were taking at the time. Another moral hazard that contributed to the financial crisis was the collateralization of questionable assets. In the years leading up the crisis, it was assumed lenders underwrote mortgages to borrowers using languid standards. Under normal circumstances, it was in the best interest of banks to lend mony after thoughful and rigorous analysis. However, given the liquidity provided by the collateralization debt market, lenders were able to relax their standards. Lenders made risky lending decision under the assumption they would likely be able to avoid holding the debt through its entire maturity. Banks were offerd the opportunity to offload a bad loan, bundled with good loans, in a secondary market through collateralized loans, thus passing on the risk of default to the buyer. Essentially, banks underwrote loans with the expectation that another party would likely bear the risk default, creating a moral hazard and eventually contributing to the mortgage crisis. The financial crisis of 2007-2009 was, in part, due to unrealistic expectation of financial institutions. By accedent or design - or a combination of the two - large institutions engaged in behaviour where they assumed the outcome had no downside for them. By assuming the government would opt as a backstop, the bank action were a good example of maral issue and behaviou of poeople and institutions who think they are given free option.