Question

Define moral hazards in a banking system. How would increased moral hazards affect an economy's financial health?

Answer 1

As an overview, moral hazard can be broadly defined as the scenario where one party ( bank in this case ) get engaged in excessive risk taking with the knowledge that it will be protected against the risk.

In order to discuss the moral hazard in the banking system, it is important to go back to 1998 when the hedge fund Long Term Capital Management was bailed out by the central bank ( in-sync with the government) since the failure of the fund could have triggered a broader financial crisis.

This gave the "too big to fail" banks a cue that the federal reserve and the government was ready to bail out banks if they were facing a collapse. The result was that the banking system engaged in excessive risk taking and leveraging before the financial crisis of 2008--09.

When the banks faced rising non-performing assets and crisis due to leverage, it was the central bank and the government that stepped-in and bailed out these banks with the help of taxpayer money. This is the core concept related to moral hazard in the banking industry.

When banks engage in excessive leveraging and risk taking, the entire financial system and economic system is as risk. The reason is that under the fractional reserve banking system, the banks are a backbone of economic growth and money supply to the economy.

The 2008-09 crisis serves as a good example when the banking system had to be bailed out and there was a complete credit freeze. This translated into sharp decline in money supply and asset deflation. Further, businesses and consumers suffered and the eventual result was a deep recession. It was the banking sector that triggered a crisis for the whole economy.

Therefore, moral hazard in the banking system needs to be avoided and this can be done through higher oversight on the banks. In addition, banks engaging in excessive risk taking or speculation should be allowed to fail while protecting the depositors.