JPI Spring 2018

Financial and Political Implications of Moral Hazard
During the Great Recession and for Future Markets
Georgina Tzanetos
Moral hazard is defined as taking excessive risk when one is protected from its consequences.
In its everyday form, it could be as simple handling the clutch too rough in a rental car when you’d be
far more careful in your own. In its more complicated and dangerous form, banks receive exorbitant
capital when they are in distress. Hazard is realized when institutions behave in a risky way and fall
back on the reassurance from some other, larger institution. Banks, and countries, get “bailed-out”
when they are deemed too big to fail, or when too many banks are failing simultaneously. 1 Some
literature supports the idea that bail-outs aim to prevent bank runs, reduce the social cost of bank
failure, and promote financial stability, but other studies suggest that these safety-nets perpetuate
moral hazard in the form of excessive risk-taking behavior. 2 The Great Recession brought banks and
entire sovereigns to exercise enormous amounts of uncovered risks in pursuit of profit, utilizing
disproportionate actions relative to their respective economic environments. In this paper I will
identify these patterns and their implications for the future. Moreover, my aim is to contribute to the
conversation surrounding interconnected markets regarding responsibility. I will demonstrate,
evidenced through researchers, that even economic strongholds like Germany and the United States
exercised recklessness comparable to smaller, less-dominant economies that took the brunt of the
blame during the Great Recession.
One challenge in the discussion of moral hazard is identifying where the problem truly exists.
Financial institutions and sovereign states, even if otherwise properly managed, can be financially
distressed due to exogenous shocks. Dam and Koetter point out that these types of situations do not
give sufficient evidence for moral hazard. 3 They argue that problems only arise from additional risktaking
due to higher bailout expectations. For example, our driver won’t assume the costs should the
clutch fail out by way of insurance reimbursement. Reckless behavior under the auspice of coverage
is behavior researchers have found across political institutions as well. Countries and financial
institutions are just as likely to take an additional risk given an already tumultuous climate. Countries
with uneven national balance sheets repress wages yet continue to lend, and highly indebted financial
institutions offer loans to those who cannot afford them. 4
Problems arise from the additional risk that banks and countries take due to higher bailout
expectations, which are typically not observable. For the purposes of this paper, it would be helpful
to know them up front, but I move forward operating under the assumption that central bank leaders
and global finance ministers prefer to keep their egregious expectations of financial safety nets to
themselves. Thus, I will present political and economic factors that can predict bailout expectations.
Researchers have used this method and believe that political factors are suited for the identification
of moral hazard effects as they explain bailout probabilities, but do not directly affect risk taking. 5
1
Maureen Ohara and Wayne Shaw, “Deposit Insurance and Wealth Effects: The Value of Being ‘Too Big to Fail,’” The Journal of Finance, vol. 45, no. 5
(1990): 1587. doi:10.2307/2328751.
2
G. Gorton and L. Huang, “Liquidity, Efficiency, and Bank Bailouts,” American Economic Review, vol. 94 (2002): 455-83.
3
Lammertjan Dam and Michael Koetter, “Bank Bailouts and Moral Hazard: Evidence from Germany,” Review of Financial Studies, vol. 25, no. 8 (May
2012): 2343–2380. doi:10.1093/rfs/hhs056.
4
Dam and Koetter; Jörg Bibow, “The Euro Debt Crisis and Germany’s Euro Trilemma,” SSRN Electronic Journal (2012), doi:10.2139/ssrn.2060325.
5
Dam and Koetter.
JPI Fall 2017, pg. 26