Describe in detail how the early 21st century financial crisis came about being specific to point out structural change in the financial sector as well as other actions or failures to act that resulted in the creation of moral hazards.
Misguided Intervention in the US Housing Market
The federal government misguided intervention into the US housing was motivated by a long-standing desire to expand home ownership, especially to low-income households. This included mortgage interest deduction in the tax code, “affordable lending” requirements and legislation such as the Community Reinvestment Act (1977), both of which pressured bankers to make loans to people with poor credit, and the establishment of massive government mortgage behemoths, the most prominent of which were the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac.
Loose US Monetary Policy
The US monetary policy also contributed to the crisis. The monetary policy objectives are to control inflation and protect the stability of the real economy. However, the Federal Reserve of US has considerable discretion in how to achieve these objectives which is acutely dependent on the views of policy makers. The Greenspan Doctrine, set out in 2002, allowed the Fed the do nothing to stop asset bubbles from occurring, but would stand by to cushion the fall if they did occur. This means a partial bailout of bad investments and produced the so-called Greenspan put – an option to sell depreciated assets to the Fed.
Another concern of Fed policy makers has been fear of deflation. In late 2002, then-Governor Bernanke persuaded Alan Greenspan that the main danger facing the US economy was the prospect of it falling into a Fisherian debt-deflation spiral that led the Fed to put its foot on the monetary accelerator and squeeze the Fed funds rate down to just over 1% in July 2003, and to keep it at that level for a year.
The impact of deposit insurance on the banking system is in fact both profound and highly destabilizing. In this system a banking system that has no deposit insurance at all where depositors’ funds are at risk, but depositors know this and have an incentive to be careful where they make their deposits. The bankers also know this, and know that they have to cultivate the confidence of their depositors: lose that confidence and the bank will face a run.
Therefore the banker needs to be prudent where risktaking has to be moderate and maintaining levels of liquidity reserves and risk capital by the bank that are high enough to retain depositor confidence. The financial health of the bank is ultimately determined by public demand in that if the public want safe banks, they get them. However, the public has to pay for what they get: if they want banks to take moderate risks, be strongly capitalised, then they have to accept relatively low interest rates on their deposits, and they have to pay relatively high rates on their loans.
Financial regulation is another policy failure. Financial regulation was meant to ensure the stability of our financial system and it is clear that it hasn’t worked. However, I would suggest that there was never any good reason to think it would.
A moral hazard is where one party is responsible for the interests of another, but has an incentive to put their own interests first. Financial examples include the following:
• selling you a financial product (e.g., a mortgage) knowing that it is not in your interests to buy it.
• pay for excessive bonuses out of funds that I am managing on your behalf; or
• taking risks that you then have to bear.
Moral hazards such as the financial system and of the economy more generally are persuasive. Keeping them under reasonable control is one of the principle tasks of institutional design. In fact, it is no exaggeration to say that the fundamental institutional structure of the economy – the types of contracts we use, and the ways that firms and markets are organized – has developed to be the way it is in no small part in response to these pervasive moral hazards.
. How do you think we should react as a society?
Measures that rein in moral hazard are to be welcomed and will help to reduce excessive risk-taking; measures that create or exacerbate moral hazard (such as massive bailouts?) will lead to even more excessive risk-taking and should be avoided. In short, a key yardstick that should be applied to any proposed reform measure is simply this: does it reduce moral hazard or does it increase it?
The bottom line is If someone takes a risk, someone has to bear it. If I take a risk, then we want to ensure that I be made to bear it. But if I take a risk at your expense, then that’s moral hazard and that’s bad. As the late, great, Milton Friedman might have put it: there ain’t no such thing as a free risk.
If you were in charge, how would you reorient the financial sector and/or any aspects of the U.S. legal system, etc. to prevent future crises? Be as specific as possible.
Exercise prudential supervision – we should encourage regulatory system in the financial sector where banks keep healthy balance sheets and the government to keep closer look at excessive risk-taking by banks.
Quick corrective measure – a prompt action by supervisors to curb undesirable activities in the financial sector and closing down of institutions that do not have sufficient capital.
Risk management – focus should be on risk management by placing emphasis on evaluating the soundness of banks management process especially risk control.
Independence of regulatory body – because of quick response the regulatory agency requires sufficient autonomy from political process so that it is not influenced by it.