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Moral Hazard Vs.
Systemic Risk
T
he 2008 U.S. financial crisis, the
2010 sovereign debt crisis in
Europe and the current Greek
financial crisis all presented policy mak-
ers with the dilemma of having to choose
between creating a moral hazard and sav-
ing a system from systemic risk
Moral hazard means that people with
insurance may take greater risks than they
otherwise would because they know they
are protected. A moral hazard is created
when banks lend more recklessly because
they know they will be bailed out if things
go wrong. Bailing out the banks reinforces
the belief they will be protected from reck-
less lending, which could result in more
irresponsible lending in the future.
In similar fashion, irre-
sponsible borrowing by
governments in Europe
(Portugal, Italy and Greece)
is reinforced because they
know they will be bailed out
by the IMF, World Bank and
the European Central Bank if
things go wrong.
Systemic risk is the likeli-
hood of damage being done
to the health of the system
as a whole. It is the risk of
Jonath
collapse of an entire system
Silberm
or entire market, as opposed
to risk associated with any
one individual entity, group or component
of a system. It refers to the risks imposed
by inter-linkages and interdependencies in
a system or market, where the failure of a
single entity or cluster of entities can cause
a cascading failure, which could bankrupt
or bring down the entire system or market.
A constant concern of bank regulators is
that the collapse of a single large systemi-
cally important bank could bring down the
entire financial system. A constant concern
of the Western European nations is that a
Greece debt default will have a contagion
effect on other countries with high debt
levels that could bring down the entire
Euro project. The concern goes beyond
financial impacts to include political anxi-
eties about leaving the Euro currency and
the integration of Western Europe.
Faced with a choice between creating
a moral hazard and avoiding systemic
risk, policy makers will almost always
choose the latter. No politician or policy
maker wants to risk the collapse of the
financial system or Euro project while
they are in power. Politicians also have a
short-sightedness bias. This is because the
consequences of systemic failure are imme-
diate and highly noticeable. The problem
of moral hazard isn't as noticeable and typi-
cally occurs sometime in the distant future
;
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54 September 10 • 2015
when the policy maker may no longer be
in office.
The overwhelming predisposition in
favor of preventing systemic risk is so
strong that it will trump long-standing
rules and economic values.
Hank Paulson, the treasury secretary in
2008, is a strong believer that free markets
should determine which institutions fail
and which do not. However, as the finan-
cial crisis loomed, Paulson and President
George W. Bush took action contrary to
their long-held beliefs about the economy
to avoid risking the collapse of the finan-
cial system and took action that created a
moral hazard.
With Greece, the IMF violated its long-
standing rule under which it
would not lend to a country unless
a rigorous analysis showed that
there was a "high probability that
debt will remain sustainable
In 2010 the IMF wrote an open-
ended exemption. New loans can
be made in unsustainable situa-
tions so long as there was a "high
risk of international systemic spill-
over." The IMF claimed this was
the case with Greece, and Greece
got their loans in 2010. More
recently, Greece was bailed out
again to avoid systemic risk
After the financial crisis,
the proposed solution to avoiding the
moral hazard vs. systemic risk dilemma
is to enhance government regulation.
Proponents of the 5-year-old Dodd-Frank
financial reform legislation argue it will
eliminate the problem of systemic risk and
so-called "too-big-to-fail" financial institu-
tions through capital controls, living wills
and a commission tasked with identifying
systemically important financial institu-
tions.
This approach can be problematic for a
number of reasons. Regulator memory of
the crisis fades over time; regulations do
not keep up with new technology; market
conditions change; unintended conse-
quences arise; and regulatory capture sets
in. Regulatory capture is the process by
which regulatory agencies eventually come
to be dominated by the very industries they
were charged with regulating.
Escaping the moral hazard-systemic risk
dilemma through Dodd-Frank is improb-
able. A superior approach is to find the
balance between market discipline and
government regulation.
❑
Jonathan Silberman is a professor of econom-
ics at Oakland University. He writes a monthly
column on the economy for the JN. You can
contact him at silberma@oakland.edu.