Why are bail outs of failing banks a potential cause of moral hazard in financial markets?
Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC, NCFE, Pearson BTEC, CIE
Last updated 8 Dec 2024
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Government bailouts of failing banks can lead to moral hazard in financial markets because they
change the risk-reward calculus for banks, investors, and other financial institutions. Moral hazard
arises when entities engage in riskier behaviour because they believe they will not bear the full
consequences of their actions, as someone else (in this case, the government) will absorb the
losses. Here’s how this applies to bank bailouts:
1. Reduced Incentive for Prudence
When banks are rescued by government bailouts:
Management Behaviour: Bank executives may take on excessive risks, such as high-risk lending or
speculative investments, believing that if those risks lead to failure, the government will step in to
save them.
Shareholder Expectations: Investors may support risk-taking strategies for higher returns,
assuming that potential losses will be mitigated by a bailout.
2. Encouragement of "Too Big to Fail" Mentality
Banks and financial institutions that are large or systemically important may assume they will
always be bailed out because their failure could destabilize the financial system. This leads to:
Excessive Growth: Large banks may expand aggressively, ignoring prudent risk management, to
solidify their "too big to fail" status.
Distorted Competition: Smaller institutions, knowing they are less likely to receive bailouts, may
face unfair competitive disadvantages.
3. Undermining Market Discipline
In a free-market system:
Financial institutions are supposed to bear the consequences of poor decisions, creating a natural
check on excessive risk-taking.
Bailouts disrupt this mechanism by shielding banks from the full consequences of failure, reducing
incentives to self-regulate.
4. Increased Risk-Taking in Broader Financial Markets
Investors' Perspective: Knowing that governments might intervene during crises, investors may
overlook systemic risks and demand lower risk premiums, which can inflate financial bubbles.
Interbank Lending: Other financial institutions may be more willing to lend to risky banks,
assuming that government support minimizes the risk of default.
5. Fiscal and Social Costs
Bailouts often use public funds:
The perception that taxpayers will bear the costs of rescuing reckless financial institutions can
erode trust in the financial system.
It also creates a moral dilemma: Should public resources be used to shield private institutions from
their failures?
Real-World Examples
2008 Financial Crisis: The U.S. government bailed out several banks and financial institutions,
including AIG, to prevent systemic collapse. Critics argue this reinforced moral hazard, as
institutions assumed future safety nets.
European Sovereign Debt Crisis: Banks that held risky sovereign debt expected that governments
or international bodies (e.g., the European Central Bank) would intervene to stabilise markets.
Balancing Act
While bailouts are often necessary to prevent systemic crises, governments must address moral
hazard by:
Imposing Conditions on Bailouts: Require strict repayment terms, caps on executive
compensation, and restructuring plans.
Strengthening Regulation: Introduce robust regulatory frameworks to ensure financial institutions
manage risks prudently.
Creating Resolution Mechanisms: Establish systems to wind down failing banks in an orderly
manner without using taxpayer funds.
Promoting Accountability: Hold management and shareholders accountable for losses, ensuring
they bear the costs of failure.
Addressing moral hazard is critical to fostering a stable and responsible financial system while
maintaining the ability to respond to crises effec
Managing and assessing risk
Line-of-business executives look to their financial managers to assess and provide compensating
controls for a variety of risks, including:
Market risk
Affects the business’ investments as well as, for public companies, reporting and stock
performance. May also reflect financial risk particular to the industry, such as a pandemic affecting
restaurants or the shift of retail to a direct-to-consumer model.
Credit risk
The effects of, for example, customers not paying their invoices on time and thus the business not
having funds to meet obligations, which may adversely affect creditworthiness and valuation,
which dictates ability to borrow at favorable rates.
Liquidity risk
Finance teams must track current cash flow, estimate future cash needs and be prepared to free
up working capital as needed.
Operational risk
This is a catch-all category, and one new to some finance teams. It may include, for example, the
risk of a cyber-attack and whether to purchase cybersecurity insurance, what disaster recovery
and business continuity plans are in place and what crisis management practices are triggered if a
senior executive is accused of fraud or misconduct.
