Define moral hazard in a financial sense. What must be present for moral hazard to arise? Describe the moral hazard that occurred with the Great Recession of 2007 - 2009. How could this type of behavior be avoided in the future?
What will be an ideal response?
Moral hazard is the action whereby one party takes inappropriate risks because they believe that they will not suffer the full consequences of a failed action. In a financial sense this means making a risky investment where one party receives the benefits if things go well, but shares or otherwise suffers few of the consequences if things go bad.
For moral hazard to exist there must be asymmetric information with the risk-taker having the greater information. A rational investor would not willingly be at an information disadvantage without some type of contractual safeguard. During the Great Recession financial institutions purchased assets and issued derivative securities they knew to be of greater risk than generally known. Subprime mortgage loans are a good example. Lenders were willing to originate the loans and pass along the risks. Large financial institutions felt able to purchase such asses because they were "too-big-to-fail" for the financial system and therefore in the event of payment defaults the institutions would be able to share the loss with regulatory agencies.
Greater transparency to minimize asymmetric information, stricter regulatory oversight to assure a rational and efficient market, and elimination of the too-big-to-fail doctrine may reduce the moral hazard problem in the financial services industry.
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Which is true?
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