Data Bases • Custom Term Papers • Free Term Papers • Free Research Papers • Free Essays • Free Book Reports • Plagiarism? Links • Top 100 Term Paper Sites • Top 25 Essay Sites • Top 50 Essay Sites • Search 97,000 Papers @ DirectEssays.com • Search 101,000 Papers @ ExampleEssays.com • Search 90,000 Papers @ MegaEssays.com Free Essays • Term Paper Sites • Chuck III's Free Essays • Free College Essays • TermPaperSites.com • My Term Papers • Get Free Essays • Essay World • Planet Papers	Search Lots of Essays Back to Subjects - Economics Moral Hazard in Banking Moral Hazard in Banking Moral hazard is an asymmetric information problem that occurs after a transaction. In essence, a lender runs the risk that a borrower will engage in activities that are undesirable from the lender's point of view, making it less likely that the loan will be paid back. Gary H. Stern's article, "Managing Moral Hazard with Market Signals: How Regulation Should Change with Banking", addresses the moral hazard problem inherent to the financial safety net provided by the government protection of depositors. Interest rates do not reflect the risk associated with bank activity, which in turn causes banks to finance higher-risk projects with price tags that are not parallel to the risk level. A solution to the moral hazard problem lies within government supervision and regulation. In the article, Stern challenges the assertion that proposals that rely exclusively on government regulation will satisfy the problem of moral hazard, especially for TBTFs (Too Big to Fail banks). Stern states several factors to support such assertions:  The ability of regulators to contain moral hazard directly is limited, due to the exploitable tactics of regulatory reform.  Limited confidence that regulation and supervision will lead to bank closures before institutions become insolvent.  The limited ability of regulators to asses bank risk due to asymmetric information and reliance of internal bank models that may be inaccurate.  The inherent subjectivity in determining how much risk in banking is too much or too little. Since banks that are deemed TBTF are regularly shielded from high rates for high risk, larger banks will take on more risk than usual. After the passage of the FDICIA, two trends have emerged that have further exacerbated efforts in regulating moral hazards. The first trend is increased asset concentration among larger banks. Over time, more assets have flowed into fewer banks, and as a result more TBTFs were incubated in the process. The second trend to emerge is increased complexity of banks. Increase of bank sizes involved not only structural growth but also geographic reach. Larger banks begin to offer a greater scope of offerings. With this plethora of change amid increased sizing, new skills needed to be developed in order to manage the new risk. The complexity and size of banks and their associated offerings caused a greater level of asymmetry between regulators and bank managers. Opponents of the safety net provided by the government have offered several alternate options, one of which is little government intervention, if at all. Such Laissez Faire approach, according to Stern, is that they do not credibly address the potential for instability in the banking system nor the TBTF problem. The absence of a federal safety net creates the potential for bank panics which would have a substantial cost to our economic system. Privatization will not eliminate the expectations in the material market making risk harder to price. Under the suggested system, the larger the institution, the more acute the problem becomes. In response to increasing TBTFs and the safety net provided by the government Stern suggested policies to address the moral hazard problem. One is developing a policy framework using market signals. This encompasses policymakers to credibly put creditors and others capable of providing market discipline at risk of loss that ultimately leads to the generations of market signals. Bank regulators are then forced to incorporate market signals into the supervisory process. This requires large banks to issue subordinated debt equal to some percentage of the bank's assets, resulting in loss of significant investments if the banks become insolvent. Subordination of debt reduces the likelihood that holders would receive coverage during a blackout. Private insurance offers another form of generating market signals, requiring market participants to assess and segment banks by their riskiness. In conclusion, total elimination of a government safety net is not the answer to solving the moral hazard problem with TBTFs. It is limiting their capacity and involvement, coupled with alternative approaches to insure against a banking institution's propensity for risk that should be the main focus. The only problem is unforeseen changes, be it structural or technological, that increases not only risk, but the likelihood that any policy that may pass will eventually be reduced in effectiveness. Bibliography: Word Count: 699
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