10.docx - Workshop based on Lecture 10 due in Week 11(last one Financial Crises and the GFC Q1 Moral hazard is where a party prioritizes their interests

10.docx - Workshop based on Lecture 10 due in Week 11(last...

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Workshop based on Lecture 10, due in Week 11 (last one!): Financial Crises and the GFC Q1. Moral hazard is where a party prioritizes their interests over others, knowing that the someone else will bear the costs. In this context, financial institutions engage in excessive risk-taking behaviour knowing that the government will bail them out because they are too-big-too-fail. Their failure would create a systemic contagion that would spread to other parts of the economy. Lenders relaxed their lending standards and made loans to subprime borrowers; these are very risky lenders with insufficient credit quality. This moral hazard was further exacerbated when these loans were securitised, meaning lenders won’t be affected if the loans default because they sold it to the SPV. At this point, financial institutions were lending as much as they could. The Dodd-Frank Act was able to reduce bank’s speculative activities, but the Financial Claims Scheme (FCS), which guarantees retail deposits up to $250K, removed credit risk and might create moral hazard. Therefore, moral hazard has not been fully eliminated. Explicit deposit insurance was introduced to prevent bank runs, but it also gives banks the incentive to take on risk, and reduces the incentives for depositors and shareholders to monitor their banks for risky activities because they know that they are insured. Q2. During the GFC, Bear Stearns was rescued in March whilst Lehman Brothers was left to collapse in September of 2008. The government reasoned that they didn’t have the authority to use the government’s money to bail Lehman out and that the financial condition has weakened so much they couldn’t find any private buyers. Lehman also failed before the TARP (Troubled Asset Relief Program), maybe it’s unlucky timing, but speculations pointed otherwise. Since moral hazard was what caused the banks to take on so much risks, the government decided not to rescue Lehman Brothers to show that they won’t bail every systemically important banks. They wanted to punish Lehman by having them responsible for their actions.
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