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In: Economics

How does the “too big to fail” increase moral hazard? Can you cite an example from...

How does the “too big to fail” increase moral hazard? Can you cite an example from the 2007- 2009 financial crisis?

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Expert Solution

Ten years ago, the global financial crisis of 2008 brought in recessions globally and fears of a complete economic collapse. They also exposed the public to a series of nonsensical financial words, ranging from "subprime lending" to "hypothecary-backed securities," "shadow banking" and "tranches." One word from the crisis is more famous than any other, though: "too big to fail." This means that certain institutions are so massive and central to the functioning of the economy that they can not be allowed to fall, no matter what.

It was the reasoning behind the US government's $182 billion loan of AIG, along with, for example, the compensation programs directed at titans such as JPMorgan Chase, Citigroup, and the Big Three car firms. Moral danger refers to a human nature observation: when people are shielded from the downside of risk, they prefer to take on more of it.

Before the financial crisis , financial firms wanted regulators not to allow them to collapse 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 granted 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 faced with a range of outcomes that they would not necessarily bear the full cost of the risks they took at the time. The 2008 financial crisis was partially due to unreasonable expectations on the part of financial institutions. By accident or design-or a combination of the two-large institutions engaged in behavior where they assumed the result had no downside. The banks acts is a perfect example of the moral hazard and conduct of individuals and institutions who believe they are giving a free choice by believing the government will opt as a backstop.


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