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Moral Hazard in Light of 2007-2008 Crisis Essay

I.Introduction

Financial crises had repeated several times such as the great depression in 1920, saving and loan crisis in 1986 and Asian crisis in 1997 before the 2007-08 financial crisis. There are a considerable number of articles about the causes of financial crises. Based on the traditional view, the causes of the financial crisis are the government budget imbalances, high inflation, low investment, low savings and low growth rate (Esquivel and Larrain, 1998). Specifically, the causes for the 2007-08 financial crisis stemmed from house price bubbles, the failure of risk management at sub-prime mortgage market and the dysfunctional ranking system and the causes are implicit in the relationship with a moral hazard. The definition of moral hazard is based on Leopold’s description (2009, p. 48): “More insurance could lead to lazier bicycle riders – a moral hazard – who enable more bicycle thefts. In finance the bicycle is risk. If I know I will be bailed out if I assume risk and fail, I’ll assume more and more risk and let you bail me out if I fail”.

It mainly arises due to information asymmetry; asymmetric information is the situation in which one party in an economic transaction has better information than the other party. Thus, in this essay, we will discuss whether the solution to a moral hazard problem is to eliminate asymmetry in the information that a borrower and a lender had in light of the financial crisis. It is structured with three parts, First we will provide evidence for the relationship between asymmetric information and a moral hazard problem; Second we will discuss other reasons causing moral hazard problems, particularly in the intervention of governments. Finally a brief summary of the discussion and the conclusion will be given.

II.The relationship between asymmetric information and a moral hazard problem

Complete information describes a condition when individuals involved could access all relevant information, and complete information definitively does solve moral hazard problem. We will analyze how moral hazard acts at the financial market and explore instances of moral hazard due to the information asymmetry in the 2007-08 financial crisis. Principal agent problem is a sub-category of the moral hazard problem; the reason is that their short-term incentives outweigh shareholders’ interest based on agents’ views. As a result, the agent or the employees do not act in the best interests of shareholders and they might hide information. Asymmetric information lies in the lack of knowledge of the principals about the consequences of the risks that the agents take to earn their bonuses. Principal-agent problems were present in the financial crisis that started in 2007 known as subprime mortgages crisis.

Subprime mortgage crisis resulted from that mortgage borrowers, mortgage lenders and investment bankers who maximized their profits without being accountable for the risks of the mortgages. Their unaccountable actions led to the spread of a large amount of sub-prime mortgages throughout the financial system. For instance, McDonald & Robinson (2009, p.185) provide a conversation with employees of New Century, which was the second-largest subprime mortgage lender, and their salesmen had annual earnings between $300,000 and $600,000. When the salesmen were asked whether they had considered the possibility of widespread default and whether proof or assets were needed before the mortgage in granted to a borrower, the salesmen responded “Not our concern.

Our job is to sell mortgage policy. Right after that it’s someone else’s problem”, and “No. They just need to state their income. No docs. That’s why we work here” respectively. This definitely shows there is asymmetry in the information between the borrower and lender because there was no requirement of proof or assets in order to get mortgages. Another example of asymmetric information occurred in the financial crisis is credit rating agencies’ failure in ranking CDOs (collateralized debt obligations).

Institutional investors such as insurers and pension funds were only to hold investment grade papers by law restricted, notably securities with a credit rating above a certain threshold. Assessment of the risk involved in holding a security is required, but credit rating agencies such as Standards and Poor and Moody have made the mistake of ranking CDOs as AAA. Hence if there was no information asymmetry, these crises could have been avoided. Information equals to power, so the more the quantity and the quality of the information that is available, the better are the possibilities to make strategic decisions that would resolve a moral hazard problem.

III.Intervention of governments

However, even if complete information is given, there are still several reasons for moral hazard problems. The principal reason is the intervention of governments. The intervention of governments contains two policies: deposit insurance and too-big-to-fail policy and loose monetary policy. Firstly, Federal Deposit Insurance Corporation, established in 1934, provides deposit insurance in order to avoid bank runs and bank panics. Diamond and Dybvig (1983) state traditional demand deposit contracts providing liquidity have multiple equilibriums; governments authorize deposit insurances that supply superior demand deposit contracts to prevent bank runs. Nonetheless, the existence of deposit insurance policy itself could be a cause of moral hazard problem because depositors realize they will not suffer losses if a bank fails under this policy.

Therefore, investors lacking motivation impose little discipline on these financial institutions. Even if there were no deposit insurance system, the investment could avoid risks and reduce losses via information about the change in banks’ portfolios (Kareken and Wallace, 1978). Another policy from the intervention of government is “too big to fail”. During the crisis, the authorities generally guarantee payment to a failing firm’s creditors or assist the bank to operate continually, which seems to stabilise the financial system and the economy. However, it might trigger the financial crisis. The moral hazard problem was deteriorated by the increase in risk of big banks non-bank financial institutions such as Lehman Brothers Holdings Inc., A.I.G, Fannie Mae and Freddie Mac.

The policy declines market discipline, discouraging depositors and investors with intensive to monitor the bank, as well as encourages excessive risk-taking by financial institution. It also provides an artificial motivation for firms to consolidate to be perceived as too big to fail (Bernanke, 2009). When the banks are taking excessive risk, there are the more possibilities of bank failures and financial crisis. Moreover, the bailout of too-big-to-fail firms is costly to taxpayers. The third reason is the loose monetary policy because greed under low-interest market still brings a moral hazard problem. Loose monetary policy including low-interest market brings intensive to seek higher profit. Greedy investors tend to take greater risk but ignore information about risk even though information circulates at the market. Consequently, the intervention of governments deprives the expected effect of complete information.

IV.Conclusion

To sum up, asymmetric information is a cause of the 2007-08 financial crisis, especially for principal agent problem and the dysfunctional credit ranking system. Salesmen’s annual salaries and bonuses are tied to short-term results such as the number of CDOs sold, rather than being tied to the long-term value of those mortgages. In addition, the dysfunctional credit ranking system raises the scale of sub-prime mortgage market and brings in a disastrous effect. The elimination of symmetric information is a reasonable solution to a moral hazard problem. Nonetheless, the intervention of governments is a hindrance to solve a moral hazard problem. Furthermore, last but not the least reason is complete information is impossible.

Because of the hugely complex details about the economic and political conditions as well as the result from financial innovations, complete information does not exist. Not only is information complex, but it also changes frequently and is not easily available. It is difficult to regulate the disclosures of all information in reality. It is difficult to deter management from hiding information or making up reports for their short-term performance, too. Although “complete information” were exposed to the public, everyone would not be able to deal with plenty information which changes rapidly. In conclusion, there still is a moral hazard problem due to the intervention of governments; while it is possible to decrease the level of asymmetric information, it is impossible to seek complete information.

V.Reference:

Bernanke, B.S. (2009), Financial Reform to Address Systemic Risk. [Online] Available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm (Assessed: 2 December 2012).

Goodhart CAE. 2008. ‘The background to the 2007 financial crisis’, International Economics and Economic Policy, 4: 331-346.

Diamond, D.W. and Dybvig, P.H., 1983.Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy, 91, pp.401-19.

Kareken, J.H. and Wallace, N., 1978. Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition. Journal of Business, Vol.51 (3), p.413-438.

Leopold, L., 2009. The looting of America: How Wall Street’s game of fantasy finance destroyed our jobs, pensions, and prosperity and what we can do about it. White River Junction: Chelsea Green Publishing, pp.48.

McDonald, L.G., & Robinson P., 2009. A colossal failure of common sense: The inside story of the collapse of Lehman Brothers. New York: Crown Business, pp.185.

Esquivel, G. and Larrain F., 1998.Explaining Currency Crises, Manuscript. [Online] Available at:


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