IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system
Which statement about moral hazard and the 'too big to fail' problem is correct?
Expectation of a government bailout lets a large institution keep the gains from risk-taking while shifting potential losses to taxpayers, which encourages excessive risk. This is why regulators impose extra capital and resolution requirements on systemically important institutions.
- AExpectation of a government rescue can encourage large institutions to take on more risk because losses may be borne by taxpayersCorrect
- BMoral hazard arises only when firms are small and unregulated
- CImplicit guarantees reduce risk-taking because managers fear nationalisation
- DToo big to fail means an institution is certain to be profitable
- Moral hazard disappears when deposit insurance is introduced
Explanation
If institutions expect to be rescued, they do not bear the full cost of failure and may take greater risks. This is why regulators add capital surcharges and resolution regimes for systemically important institutions. Deposit insurance can itself add moral hazard.
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