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In: Finance

8. Do you think government bailout of financial institutions during financial crisis of 2008 can increase...

8. Do you think government bailout of financial institutions during financial crisis of 2008 can increase moral hazard? Explain your answer.

Solutions

Expert Solution

Government bailout to financial institutons means providing the necessary aid to financial institutions during the financial crisis of 2008 as financial institutions downfall may adversely affect the economy of the country. To protect the country's economy from the recession, the government inject money into the economy and provide necessary help to financial institutions from downfall as they are the financial support to large economy. If the financial institutions goes bankrupt it will be a huge loss to the nation's economy and will result in the downturn of country's economy. To safeguard the financial institutions from bankruptcy government acts as a support to these institutions.

Moral hazard occurs when these financial institutions doesn't entered into contract in good faith and involve in risky behaviour by providing misleading information about its assets and liabilities. They take an undue advantage of government bailout by providing mortgages to customer with low creditworthiness and collateralization of questionable assets. These type of risky behaviour are undertaken by these institutions to earn a huge income in terms of interest on mortgages. Thus, when customers fail to repay the mortgage amount and become default, these financial institutions occurs a huge loss as the pool fund from mortgages are repacked in the form financial securities for other investors. Thus, government bailout may result in the increase of moral hazard. Government must be cautious when lending support to financial institutions with necessary preventive measures.


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