Chapter EMA, Problem 5DS

To determine

To state: The role of moral hazard in financial crisis.

Explanation of Solution

The financial crisis of 2008 was the consequence of several market inefficiencies, a lack of transparency in the financial sector, and bad practices. Market participants were engaged in behavior that placed the financial system on the edge of failure. 

A moral hazard is said to exist when a person or entity involves in risk-taking behavior based on a set of predictable results where another person or entity tolerates the costs in the event of an unfavorable result.

Before the financial crisis, financial institutions' anticipated that regulating authorities will not let them flop because of the systemic risk that can scatter the rest of the economy. The institutions holding the loans that ultimately added to the downfall were some of the most important and largest banks to consumers and businesses. There was the hope that if a convergence of negative factors led to a crisis, the management and owners of the financial institution would obtain special defense or support from the government. Else known as moral hazard. 

There was the assumption that some banks were so important to the economy, they were well-thought-of "too large to flop." 

One more moral hazard that led to the crisis was the collateralization of questionable assets. For many years leading to the crisis, there was this presumption that lenders guaranteed mortgages to borrowers using languid principles.

Fundamentally, banks underwrote loans with the hope that another party would likely tolerate the risk of default, forming a moral hazard and ultimately leading to the mortgage crisis.