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Moral Hazard in Financial Markets

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas

Last updated 29 Jan 2023

Moral hazard refers to a situation where one party is able to take risks because it does not have to bear the full consequences of those risks. In financial markets, moral hazard occurs when investors or market participants are able to take on excessive risk because they believe that they will be bailed out if those risks lead to losses.

There are several ways that moral hazard can occur in financial markets:

  • Too-big-to-fail: This occurs when large financial institutions are considered to be so important to the overall financial system that they will be bailed out by the government if they get into trouble. This can lead to these institutions taking on excessive risk, as they believe that they will be rescued if things go wrong.
  • Guaranteed returns: Some financial products, such as deposit insurance, can provide investors with a guarantee that they will get their money back even if the investment goes bad. This can lead to investors taking on more risk than they would if they had to bear the full consequences of that risk.
  • Complex financial products: Complex financial products, such as derivatives, can make it difficult for investors to fully understand the risks they are taking on. This can lead to investors taking on more risk than they realize, as they do not fully understand the potential consequences of those risks.
  • Short-term focus: Financial markets often focus on short-term gains, which can lead to market participants taking on excessive risk in pursuit of those gains. This can lead to bubbles and market crashes, as investors are not considering the long-term consequences of their actions.

Moral hazard can lead to destabilization of financial markets, as well as to the loss of trust from investors, regulators and the public. To mitigate this risk, regulators have implemented stricter regulations on financial institutions and products, to ensure that they are taking on appropriate levels of risk and that they have the capacity to absorb losses in case of market downturns.

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