Tuesday, September 16, 2008

Avoiding Moral Hazard: Fed Style

Moral hazard in economics
In economics and ethical theory, the term moral hazard may be used for any situation where a person or organization does not bear the full adverse consequences of its actions.

Lending and debt
Rescue operations carried out by governments, central banks, or consortiums of financial institutions can encourage risky lending, if lenders know that in case of serious problems they will not have to take losses. Similarly, if governments know that inability to pay creditors will lead to yet more loans (to prop up finances), then they are less likely to have sound financial policies.

By refusing to bailout Lehman, Fed signalled that it would longer allow moral hazard ( although it had been looking the other way and may have caused moral hazard itself when for example it brokered the Bear Sterns deal, or remember TBTF? anyone).

While its difficult not to feel sorry for the employees of firms that fail, you also know that some where atleast some of these were arrogant enough to make 'bad bets' (as they call them, almost likening it to gambling). If they had come good these guys would be reverred like gods. But now, who will pay back the investors who thought their money was safe with these geniuses.

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