Discuss the role of moral hazard and adverse selection in the 2007–2008 financial crisis.

Expert Solution

Until the financial crisis, financial firms wanted regulators not to allow them to fail because of the systemic risk that could spread to the rest of the economy. Many of the largest and most important banks for companies and customers were the institutions holding the loans that ultimately led to the downfall. There was the hope that if a confluence of negative factors led to a crisis, the financial institution's owners and management would be given special protection or assistance from the government. Otherwise named moral hazard.

There was the expectation that certain banks were so important to the economy that they were deemed "too large to fail." Despite this belief, financial institutions stakeholders were presented with a range of outcomes that they would not necessarily bear the full cost of the risks they took at the time.

Imperfections in information, like asymmetric information, are significant frictions in financial markets.
Also in normal times, credit market investors frequently know more about the quality of collateral and the riskiness of their investments than the lenders. If ex-ante borrowers at high and low risk are similar, then high-risk borrowers gain at the detriment of low-risk borrowers. The resulting adverse selection issue (when high-quality borrowers choose not to take part in the market) leads to higher interest rates and a decline in lending.

In the recent financial crisis, adverse selection in the subprime mortgage industry led to freezing of the industry and hoarding liquidity. Increasing uncertainty about asset prices, a flight to liquidity,8 and underestimation of systemic risk exacerbated the adverse selection effect and propagated it to the entire financial system

Rahul Sunny answered 7 months ago

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