the authors define the moral hazard problem of insurance to be: “insuring people
ID: 1208938 • Letter: T
Question
the authors define the moral hazard problem of insurance to be: “insuring people against losses removes the incentives of the insured to act so as to reduce the risk of these losses”.
The Too-Big-To-Fail policy is the doctrine whereby a financial institution facing failure is rescued (“bailed out”) by the government if its failure is viewed as posing a threat to the financial system.
In 1984, a very large commercial bank (“large” for that time), Continental Illinois, looked to be in trouble due to a string of losses on its assets. While deposits up to $100,000 were insured, larger depositors had deposits in the tens of millions, that is, they had deposits that were mostly not insured. In addition, “Conti” had a number of large outstanding debts to other large financial institutions. Finally, more than 2000 smaller banks had deposits at Conti, and for many of these smaller banks, the deposits constituted a significant percentage of their total capital.
The government judged that Conti was too big to fail and bailed out the bank.
The question for you is: how is moral hazard relevant here?
Explanation / Answer
Moral hazard is one of the basic concepts in economics. Say, if someone pays you for your accidents, you will expend less effort trying to avoid it. A government bailout increases moral hazard by engendering a business climate in which companies feel they will be protected from the consequences of poor decisions and risky behavior. If the government steps in and tries to bail out a bank, consequences extend to everyone in society. Tax payers have to shoulder the cost of bailouts.
Moral hazard occurs when a person or firm is shielded from the behavior of his or its bad behavior or poor decision making, and therefore, acts indifferently. Conti’s behavior was irresponsible, making risky loans, trading in risky derivatives, and operating inefficiently. For certain, the government bailout shifted the consequences of bad behavior from the bank’s executives to innocent taxpayers. This is the moral hazard in a nutshell.
*****
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.