Moral Hazard and the Financial Crisis - Research Paper Example

?Moral Hazard and the Financial Crisis Table of Contents Table of Contents 2 Introduction 3 Theoretical Explanation of Moral Hazards as a Cause of Financial Crisis 4 Historic Evidences of Moral Hazards Causing Financial Crisis 5 Moral Hazards in the Asian Financial Crisis Situation of 1990s 5 Moral Hazard in the 2008 Financial Crisis 6 Evidences of Moral Hazards in Financial Crisis 8 Conclusion 11 11 Works Cited 12 Introduction Controversies have been raised both in the educational arena and the professional contexts surrounding the phenomenon of moral hazards as a major cause for disruptions in the industrial processes, especially concerning those activities which have been dependent on the financial system of any economy. To be explained in simple words, moral hazards fundamentally occur due to the irresponsible acts conducted by one or more parties to avail benefits from the legal or social agreements disregarding the interests of the other allied members. In the present business phenomenon, moral hazards have emerged as a major issue of concern which needs enthusiastic initiatives to develop awareness among the industry participants. Moral hazards normally occur when people file more claims or stick longer to a particular claim irrespective of the consequences likely to occur due to such perseverance causing massive disruptions to the smooth functioning of the industry operations (Butler and Gardner 1). Contextually, it has often been argued that moral hazards have been one of the fundamental reasons for the recent financial crisis where various operations conducted by the financial institutions were observed to disregard their ethical responsibilities towards the various community groups. As stated by Dowd (1), policy measures adopted by financial institutions practicing free markets were the underlying causes to the financial crisis witnessed in 2008. Based on this context, the paper will intend to discuss the moral issues related with the occurrence of the financial crisis in 2008 signifying the importance of ethical concerns when designing and implementing policy measures at a country-level. Theoretical Explanation of Moral Hazards as a Cause of Financial Crisis Moral hazards are said to occur when the interests and rights of one party is compromised for the benefits or interests of the other party(s) engaged in the process In the current day context, critiques often argue that moral hazards have today become a persistent and unavoidable occurrence in the financial system of any country that in turn severely affects the stability of any economy. It is worth mentioning in this context that moral hazards are the apparent consequences of intentional or unintentional ethical misconducts by decision makers associated with the various business dimensions. However, in common instances, unethical behaviors conducted at the organizational level by company executive are scrutinized for the critical assessment of the financial and social positioning of a particular brand. Although in the context, ethical misconducts may also occur at country level policies fundamentally those which are directed with the intention to manage industry operations in monetary terms (Nowak and O’Sullivan 147-150). In the country-level assessment, occurrences of moral hazards have often been considered to play a prominent role in financial crisis situations. Historic evidences have also revealed that moral hazards within the policy making dimension have caused serious disruptions in the regular business functioning in a particular economy (Isard 193-200). These evidences can be further assessed from two perspectives, i.e. the social perspective of moral hazards and the economist perspective of moral hazards. From a social perspective, moral hazards are criticized as the fundamental causes of systematic risks in the business context. It is in this context that socialists have often depicted their concern towards the role played by moral hazards in causing industrial threats for systematic risks which is recognized as an initial shock in the organizational level and through an ineffective financial system or policy enforcement, gets channelized to the various dimensions of the economy (Dow, “What Is Systemic Risk? Moral Hazard, Initial Shocks, and Propagation”). Similarly, economists have often related the effects of moral hazards with the theories of Keynesian economics depicting the inclination of financial institutions and economic policy makers towards creating a “free market” or “free competition” which in turn results in crisis situations (Dowd, “The Nature of Moral Hazard”). Historic Evidences of Moral Hazards Causing Financial Crisis Critiques have often taken the assistance of historic events confirming financial crisis situations in assessing the role of moral hazards. In this particular section, case references from the occurrence of Asian financial crisis of the 1990s and Financial crisis of 2008 have been considered. Undoubtedly, both these financial crises situations have been historic evidences of financial policy failures in a particular economy which have further channelized in various allied economies within the global circle expanding the consequences of the turmoil. Thus, these two case scenarios shall be the most appropriate illustrations to give an account of the role played by moral hazards in causing financial crisis. Moral Hazards in the Asian Financial Crisis Situation of 1990s During the Asian Financial Crisis in the 1990s, it was observed that financial mediators who accepted implied guarantees deciphered an inclination towards investments that are too risky but involve highest returns. Implied guarantees, in this scenario, also provided extensive incentives to international lenders owing to the high degree of flexibility possessed by the enforced managerial control and risk management. Political pressures on the financial institutions to provide credits to the local firms and industries at lower interest rates further acted as a fuel in this crisis situation causing a fiscal deficit in Asian countries allied through international trade relations. Consequently, due to such lending policies, projects with unconstructive values and high risks were financed at lower interest rates causing a financial crunch within the economy. This particular fault in the interest rate policies enacted within Asian countries further led to the overvaluation of prices of assets and caused imbalances within the financial structure of the economies by influencing the capital inflow negatively. These policy measures were further criticized to be the consequences of moral hazards whereby, the policy makers rendered due significance towards encouraging financial borrowings mis-conceptualizing the notion that greater financial borrowing is likely to encourage capital inflow in the economy and thereby strengthen its position in the global market. In other words, policy makers disregarded the probable consequences to be caused due to such unplanned measures and the risks associated with the projects financed which illustrates their unethical conduct and thus can be noted as an occurrence of moral hazards (Chang, “Moral Hazard in The Asian Crisis”). Moral Hazard in the 2008 Financial Crisis A repeat instance of moral hazards causing financial crisis situation within an economy and correspondingly in various allied economies constituting the industrial belt can be observed with reference to the occurrence of the financial crisis in 2008. Critiques have argued in this regard that moral hazards again had a considerable role to perform in the occurrence of financial crisis 2008. The financial crisis of 2008 was later investigated to be rooted in 2007 when BNP Paribas, one of the leading global banks, announced or rather pinpointed the risks associated with the subprime mortgage policies being practiced in the US. This particular concern further attracted the sight and awareness of market lenders which motivated them to re-value the assets which were already overvalued due to the mortgage loans facilitated by the banks in the nation. As a consequence, it was observed that a significant abyss persisted in the financial accreditation of the assets allowed through mortgages by international banks such as Northern Rock which caused liquidity gap in the housing market. Gradually with the passing time, by the 2nd quarter of 2008, the stock market in the US started plummeting causing the housing bubble within the economy where one after another banks started collapsing due to the rising pressure of repaying the mortgaged amount in the international market (Kingsley, “Financial crisis: timeline”). Apparently, such drastic failure of lending policies practiced in the US during 2007-2008 illustrates the conduct of moral hazards where the sole interests of increasing capital flow in the country was considered as vital; somewhat disregarding the interests of the long-run stability of the nation’s liquidity position. The policy makers and subsequently the large financial institutions had failed to judge the consequences of their interest rate policy measures which were quite likely to cause social disruptions and economic fluctuations in the long run by creating a liquidity crisis within the economy. The unethical conducts or rather the lack of responsible acts performed by the financial institutions can be further noted as the fundamental aspects associated with the occurrence of the moral hazards leading to the 2008 financial crisis. It was in the year 2007 that every financial institution, especially the large multinational banks had started realizing their failure in preserving the economic stability and had to witness the apparent consequences of assets overvaluation, huge borrowings from the international market and withdrawal of savings made due to the massive fluctuations in the stock market (Froeb and McCann 260-262). Hence, the banks aimed at recovering their finances allowed in terms of mortgage loans to the nationwide customers at lower rates and also with high risks which further caused the housing bubble in the US and as a result increased the inflationary rates within the economy to record hikes. Another major moral issue identified in this particular occurrence of 2008 financial crisis was the poor, irrational and unethical underwriting practices of financial lenders to mortgages which created a liquidity trap for the nation thus, playing a major role in causing the housing bubble in 2008 (The Financial Crisis Inquiry Commission, “Final Report Of The National Commission On The Causes Of The Financial And Economic Crisis In The United States”). Evidences of Moral Hazards in Financial Crisis This particular instance can be better explained with reference to the case scenario of Northern Rock. It was precisely during the month of September in the year 2007 that Northern Rock was under the impression to going bankrupt. Owing to its policy decision to take huge sums of loans with the aim to facilitate low interest rate mortgage loans to the customers ignoring the high risks associated with such initiation and thereby deciphering an attitude of moral hazard in terms of ethical misconducts. In order to repay its huge sum of debt, Northern Rock thus had to sell its mortgages in the international financial markets. The pressure to resell its mortgages to recover its debted amount further increased with the continuously falling demand in the capital market of the global arena causing a liquidity crisis for the bank. Consequently as soon as the information that Northern Rock is under huge debts flowed to its customers, the British bank had to witness tremendous pressure from its customers’ end as well to recover their savings which further led the bank to a more vulnerable situation. Ultimately, the bank was forced to collapse due to its failure to recover the debted amount and thus led to collapse (Kingsley, “Financial crisis: timeline”). The effects of the financial crisis occurrence in 2008 were continuously being witnessed over the next few years. During its aftermath, not only the financial institutions operating both in national and international market continued collapsing, but negative effects of the consequences led by this financial crisis was also apparent among various other industries including the automotive industry sector. For instance, Ford Motors, General Motors, and Chrysler among other world reputed automotive brands were observed to face significant disruptions in preserving its financial strengths being pressurized by the dipping purchasing power of the customers on one hand and rising competition on the other. However, with the virtues of their leadership skills and competencies, these companies were able to sustain in the financial crisis situation, many sub-brands owned by these companies had been recorded to be collapsed or sold to maintain the margin of its capital ratio (Clark, “Automotive industry: Carmaker Ford facing dire financial crisis”). The lending policies enacted by the International Banks for Reconstruction and Development (IRBD) were also criticized as a source that provoked moral hazards during the financial crisis of 2008. For instance, the effects of the lending policies practiced by IBRD irrespective of the budget insufficiency deciphered by the recipient countries can be identified as a moral hazard where sole concern was rendered towards the short term goals deciphering disregard for the long-run sustainability of the economic components not only in the national context but also in the periphery of international trade. To be specific, moral hazards related with the policy conducts of IBRD caused a direct affect on the political cycle of national as well as international businesses making the crisis situation more expanded (Dreher, “Does the World Bank Cause Moral Hazard and Political Business Cycles?”). International Monetary Fund (IMF) implemented funding policies in terms of bailouts were also not without the criticism by economists on the grounds of moral hazards. Bailouts are described as the borrowing facilities rendered by international financial bodies to rescue and support economies facing significant challenges in terms of liquidity crisis situations or budget deficits. As criticized by various economists, the vision of potential “bailouts” increases not only extreme lending to emerging economies at interest rates that do not effectively reflect the primary danger, but also negligent policies and therefore deciphering an attitude of moral hazard (Rogoff, “Moral Hazard in IMF Loans How Big a Concern?”). Additionally, the economic behavior deciphered by the government of US in terms of extending guarantees to the countries that are undergoing extreme financial difficulties was also criticized on the basis f moral hazards in context to the financial crisis of 2008. As investigated during the crisis situation, by encouraging extreme risk taking, the federal guarantees threatened huge losses to the US taxpayers amounting to $150 billion for the economy bailout which further caused a negative impact on the US treasury making the circumstances more vulnerable and worse (Hoskins and Coons, “Mexico: Policy Failure, Moral Hazard, and Market Solutions”). Conclusion As can be observed from the above discussion, moral hazard can undoubtedly be characterized as a significant concern all over the world, especially when it comes to financial policy enactments and the socially responsible concerns of the economic decision makers. Taking the case references of both the financial crisis situations in the 1990s and the year 2008, it becomes quite apparent that disregard to long-run sustainability, as well as imbalances and sightlessness of the policy makers had been the sole reasons for moral hazards which in turn led to the failure of the entire economic structure. Furthermore, owing to the 21st century international trade practices, which focuses more on the creation of free market, further causes the risk of rapidly increasing sphere of the financial crisis effects. Stating precisely, as economies are recently observed to become increasingly interdependent, it has emerged as a vital concern for the global players to render due significance towards identifying and subsequently rectifying moral hazards at the bottom-level. Conclusively, it can be suggested that moral hazards need to be given significant concern to ensure long term sustainability of economic performances as it acts as one of the sole reasons for financial crisis as observed with reference to historic evidences. Works Cited Butler, Richard J and Gardner, Harold H. Moral Hazard and Benefits Consumption Capital in Program Overlap. Boston: Now Publishers Inc, 2011.Print. Chang, Ha-Joon. “Moral Hazard in the Asian Crisis”. World Development. 28 (2000): 775-788. Print. Clark, Andrew. Automotive industry: Carmaker Ford facing dire financial crisis. The Guardian. 2012. Web. 21 Feb. 2013. Dreher, Axel. Does The World Bank Cause Moral Hazard and Political Business Cycles?. Evidence from Panel Data.2001. Web. 21 Feb. 2013. Dow, J. “What Is Systemic Risk? Moral Hazard, Initial Shocks, and Propagation”. Monetary and Economic Studies, (2000). Print. Dowd, Kevin. “The Nature of Moral Hazard”. Moral Hazard and the Financial Crisis. 2009. Web. 21 Feb. 2013. Froeb, Luke M and McCann, Brian T. Managerial Economics: A Problem Solving Approach. India: Cengage Learning. 2009. Print. Hoskins, W. Lee and Coons, James W. Mexico: Policy Failure, Moral Hazard, and Market Solutions. Policy Analysis. n.d. Web. 21 Feb. 2013. Isard, Peter. Globalization and the International Financial System: What's Wrong and What Can Be Done. Cambridge University Press, 2004. Print. Kingsley, P. Financial crisis: timeline. The Guardian. 2012. Web. 21 Feb. 2013. Nowak, Alojzy Z. and O’Sullivan, Patrick. Ethical Issues in Policy Response to the 2008 Financial Crisis: Moral Hazard in Central Banking and the Equity of Bailout in Business Ethics: A Critical Approach: Integrating Ethics across the Business World. Routledge, 2012. Print. Rogoff, Kenneth S. “Moral Hazard in IMF Loans How Big a Concern?”. International Monetary Fund. 39 (2002). Print. The Financial Crisis Inquiry Commission. Final Report Of The National Commission On The Causes Of The Financial And Economic Crisis In The United States. Official Government Edition. 2011. Web. 21 Feb. 2013. Read More