Question

What is moral hazard? Identify 2 regulations in the Frank-Dodd Act that affects moral hazard behavior of banks. Explain how each one increases or decreases the moral hazard problem. Be specific. \

Answer 1

Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others. Examples of moral hazard include Governments promising to bail out loss-making banks can encourage banks to take greater risks.

Dodd Frank Act

An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

Two important factors that lead to moral hazard problems are deposit guarantee by the government and bailout programs for the financial institutions that later affect banking operations negatively. Moral hazard can bring an outsized shock to the financial system of a country specifically to the banking sector. At the end of the paper, an attempt also made to provide a solution to the identified moral hazard problem.

There are several ways to reduce moral hazard including incentives, policies to prevent immoral behavior and regular monitoring. At the root of moral hazard is unbalanced or asymmetric information. The benefit of the asymmetric information often occurs after the transaction has concluded.