During the financial crisis of 2007 -2009, the Federal Reserve used its emergency authority to lend to shadow banks. Explains hoe this extension of the lender of last resort function added to moral hazard.
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If part of the problem was that banks were too big to fail, then by giving more money (bailout) and allowing banks to buy out other banks, you must made them bigger. From this perspective, the problem has been compounded. Moreover, if the banks got into this situation because they were reckless and made irresponsible decisions, then we just gave them more money to do the same. All of this can be seen as a moral hazard.
Shadow banks are generally much less regulated than actual banks. They tend to take on riskier investments. When the Fed acted as a lender of last resort for the shadow banks, it told them in essence that it is okay to take risks because the government will bail you out. This is almost a textbook definition of moral hazard.
The surprising thing to me is that the "shadow banking system" was allowed to grow as large as it did and to be as unregulated as it was. Paul Krugman (among others) is on record as criticizing this growth and this lack of regulation, but it would be interesting to know how many economists foresaw, predicted, and warned against the potential hazards of the growth of the shadow banking system. It is hard to understand how economists did not foresee the financial crisis developing. Perhaps they did, but, except with a few exceptions (such as Nourel Roubini), I can't recall any professional economists who predicted the crisis.
You need to examine the impact of the Fed agreeing to bail out the banks that had helped create the financial crisis because of their risky lending practices. This is of course something that basically makes the shadow banks think that they can carry on lending out money in a reckless way because they will be bailed out once again by the government with our money.
To a lot of people, the problem was the federal government getting involved at all. Some people suggest that the government should not intervene in the free markets, and especially the baking sector. This would be the moral hazard to them.
I have to support litteacher here. I think that the biggest problem was that the Federal Government became involved at all. The fact that they did lowers the moral support citizens have for the government, especially those who are struggling financially.
Moral hazard refers to the tendency of a party taking undue risks because the costs are not borne it. In almost any case where a party is given an option that it does not have to take all the responsibility for its actions the tendency to do things that would not have been done otherwise arises.
In the case of the financial bailout of banks, the moral hazard of banks taking undue risks does arise but the consequences of allowing banks to fail on a large scale on the economy could have been disastrous. This was essential to maintain the trust of people in the banking system. To reduce any abuse the Fed has to enforce strict guidelines and closely scrutinize all decisions made by those that run the banks.
"Shadow banks" refers to specific banking entities, the intermediaries of credit distribution. Examples are hedge funds (funds that hedge against risk in other investments) and derivative investments that are not listed on any exchange. An example of this last is the line of derivatives AIGFP became involved in: "began to sell credit default swaps to other financial institutions to protect against the default of certain securities." As a prime example of the Fed lending to shadow banks, AIG's global "interconnectedness" posed a mounting threat to global financial market stability and thus exercised emergency authority. It may be said that moral hazard may have been increased because the Fed opened a financial territory that had previously been outside the purvue of its power (absolute power corrupts absolutely). On the other hand, it would be remiss to discount the moral hazard of blindly allowing unmitigated global financial collapse, bearing in mind this was not the first time the Fed has activated emergency actions in its history; another instance was the Bear Sterns-JP Morgan purchase.
its size and substantial interconnection with financial markets and institutions around the world, the government recognized that a failure of AIG would have had severe ramifications. In addition to being one of the world’s largest insurers, AIG was providing more than $400 billion of credit protection to banks and other clients around the world through its credit default swap business. (AIG)
#9 has it down pat. Additionally, I will add that the OP asked about Moral Hazard, which is a highly subjective topic; it is possible that some find the actions of the Fed to be entirely moral considering the situation, while most people I have talked with agree that the cure was worse than the disease.
Morally, I think the banking system should have been forced into bankruptcy proceedings; it would have been worse in the short run, better in the long run, and would have taught everyone that actions and spending have consequences. Ripping the bandage off is better than allowing it to grow into the skin, needing an operation to remove.
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