Moral Hazard

MORAL HAZARD….How important is the effect of moral hazard in the financial marketplace? If the Fed bails out insolvent firms like Bear Stearns — even with Bear’s shareholders taking a huge bath on the deal — does this really prompt risky behavior in the future from other banks in the belief that they too will be bailed out if necessary? Martin Wolf comments:

The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

Whether the BS bailout will motivate riskier behavior in the future is impossible to know directly. But the market has spoken in one regard: the stock prices of the investment banks that Wolf refers to jumped about 20% after the bailout. The market, obviously, thinks the bailout has made risky behavior less risky and more profitable than before. As Wolf says, this is “moral hazard made visible.” Mark Thoma has more.

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