The global financial crisis that began in 2008 was caused by many market inefficiencies, unethical activities, and a lack of transparency within the financial industry. The market participants’ behaviors pushed the global economic system dangerously close to collapse. Historians will point to collateralized debt obligations (CDOs) and subprime mortgages as the primary causes of the crisis (Singh & Hossain, 2009). On the other hand, producing such a product is one thing; nevertheless, to sell and trade them, moral hazard is required. As a direct result of this, it is incontestable that moral hazard had a large role in the financial crisis that occurred in 2008.
It is not hard to see how moral hazard contributed to the disastrous outcome. A moral hazard occurs when a person or entity engages in risk-taking behavior based on anticipated outcomes in which another person or organization bears the repercussions of an unfavorable result (Dowd, 2009). A moral hazard can be avoided by not engaging in risk-taking behavior based on anticipated outcomes (Dowd, 2009). A fundamental illustration of a moral hazard is provided by drivers relying on auto insurance. As a result of the fact that fully insured drivers are only responsible for a negligible portion of the overall cost in the event of an accident, fully insured drivers face more risks than drivers who do not carry insurance. A moral hazard was created in 2008 when banks underwrote loans with the notion that a third party would carry the risk of failure. This view eventually led to the financial crisis brought on by the mortgage crisis.
Before the onset of the financial crisis, financial institutions were under the impression that regulatory authorities would prevent them from going bankrupt due to the systemic risk that the economy as a whole would otherwise incur. The banks that held the loans that eventually contributed to the collapse of the financial system were some of the largest and most important financial institutions for businesses and customers (Dowd, 2009). It was proposed that if a chain reaction of unfavorable occurrences resulted in a crisis, the government would offer owners and management of financial institutions with heightened protection or help. There was a widespread misconception that some financial institutions were too large to fail because of their significance to the economy. Given this assumption, it is quite probable that stakeholders in financial institutions did not bear the full cost of the risks they incurred at the time and contributed to the development of moral hazard.
The second instance of moral hazard during the economic debacle was using defective assets as collateral. In the years leading up to the financial crisis, there was a widespread misconception that mortgage lenders made loans to applicants with relaxed qualification standards. After conducting an exhaustive investigation, it was in the banks’ best interest, under typical circumstances, to lend money. However, given that the market for collateralized loans provided liquidity, lending institutions could lower their standards. The lenders took more risks with their lending decisions in the hope that they could get out of holding the loan until its maturity date (McDonald & Thornton, 2008). The risk of a loan going into default was passed on to the buyer when banks packaged bad loans with good loans and then sold the bundled loans to investors on the secondary market as collateralized loans. In essence, banks underwrote loans assuming that another party would likely shoulder the risk of defaulting on the loan.
Various regulatory actions were implemented to mitigate the effects and prevent further development of similar crises. The United States passed Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The Act established the Financial Stability Oversight Group, a new council of regulators dedicated to systemic risk oversight. Its purpose is to serve as an early warning system that identifies hazards in enterprises and market activity to strengthen monitoring of the whole financial system. In addition, it was intended to standardize prudential requirements among agencies. However, right-wing critics contended that it represented a massive extension of government influence over the banking sector before tackling the root causes of the financial crisis. The causes, such as the continued governmental aid to Fannie Mae and Freddie Mac, or the moral dangers they pose. In a way, it is possible to argue that despite the attempts to regulate the market and reduce associated risks these reforms did not influence the moral hazard that persisted on the market. However, the developments during the financial crisis of 2008 were at large contributing to the increase in moral hazard.
Dowd, K. (2009). Moral hazard and the financial crisis. Cato J., 29, 141.
McDonald, D. J., & Thornton, D. L. (2008). A primer on the mortgage market and mortgage finance. Review-Federal Reserve Bank of Saint Louis, 90(1), 31.
Singh, A. N., & Hossain, A. R. (2009). Collateralized debt obligations: A double edged sword of the US financial system. Economía, (27), 37-56.