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Moral Hazard

In: Business and Management

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“Anything that is too big to fail is too big to exist Simon Johnson. Discuss.

A. What does this mean? What are its implications? Before the 2009 financial crisis banks were conviced that they we're ォ too big to fail サ

Before the 2009 crisis, banks were conviced they were too important to fail in the sens that their importance in the market was such that the states could not afford to drop them. Indeed governements can't let any bank fail because of systemic risk and the need to maintain the confidence in the market and between banks.

So the banks favored the short-term profitability without thinking of the long term consequences of their decisions because they were convinced they could not fall. The banks then took advantage of their importance and jeopardized the entire economy

That's what Simon Johnson then explained by saying that 鄭nything that is too big to fail is too big to existサ, The main lesson of this crisis is that it's no longer possible to leave as much power in those institutions, indeed it's essential to reduce their size and their influence on the economy so that no futher institution can be ォtoo big to failサ

B. How is this concept related to Moral Hazard?

Moral Hazard occurs ォwhen a party insulated from risk behaves differently than it would behave if it were fully exposed to the riskサ. In that definition of moral hazard the idea of risk is very present, so we can easily see how this concept is related to the financial system and the banks. Indeed Moral hazard is the idea that banks could take unnecessary risks because they believe they池e too big to fail and would be bailed out in future crises. So moral hazard shows us how dangerous it is to have such important banks.

Thus the solution is to reduce the Moral hazard and the only way to achieve that goal is to allow banks to fail but governments...

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