Moral Hazard and Too Big To Fail
The safety net that prevents runs also creates moral hazard, because insured depositors stop monitoring and banks take more risk. For the largest banks this becomes too big to fail, where the expectation of a bailout encourages even more risk-taking.
Why it matters
If losses fall on the insurer or the taxpayer while gains stay with the bank, the bank takes bigger bets. Too big to fail sharpens this for giant banks whose collapse the government feels it cannot allow.
Worked examples
In 2008 several large institutions were rescued. What did the rescue fix, and what did it worsen?
It contained the immediate crisis and stopped the runs, but it confirmed the too-big-to-fail expectation. That is why post-crisis rules raised capital and added resolution regimes to make failure possible again.
Common mistakes
- ✗Bailouts are free money for banks. They impose costs and stigma, and they worsen moral hazard for the future.
- ✗Too big to fail only matters during a crisis. The expectation lowers big banks’ funding costs and distorts their risk-taking all the time.
Revision bullets
- •The safety net creates moral hazard
- •Too-big-to-fail banks expect a bailout and take more risk
- •Post-crisis rules raised capital and added resolution
Quick check
Too big to fail encourages extra risk-taking because large banks expect
Connected topics
Sources
- Mishkin (2018), Ch. 10Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Moral hazard from the government safety net and the too-big-to-fail problem.
- Mishkin (2018), Ch. 12Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The 2007-2009 financial crisis, the rescues, and the post-crisis regulatory response.