AQA Specification focus:
‘Moral hazard Systemic risk and the impact of problems that arise in financial markets upon the real economy.’
Introduction
This section explores moral hazard and systemic risk in financial markets. Understanding these concepts is essential to explain how issues in the financial system can destabilise the wider economy.
Moral Hazard
Moral hazard occurs when an economic agent takes on greater risk because they do not bear the full consequences of their actions.
Moral Hazard: A situation where individuals or institutions are incentivised to take excessive risks because they believe they will be protected from losses.
Moral hazard is a particular concern in the financial sector due to the following reasons:
Deposit insurance: If banks know deposits are protected, they may be more willing to lend recklessly.
Government bailouts: Banks may assume they are “too big to fail” and expect state intervention.
Complexity of financial products: Investors often cannot evaluate the risks being taken on their behalf.
Implications of Moral Hazard
Encourages excessive lending and borrowing.
Increases the likelihood of asset bubbles.
Reduces incentives for financial institutions to act prudently.
May result in resource misallocation across the economy.
Systemic Risk
Systemic risk refers to the possibility that the failure of one financial institution can trigger a chain reaction, causing widespread instability across the financial system.
Systemic Risk: The risk that the collapse or distress of a single financial institution or market segment will spread and threaten the stability of the entire financial system.
Sources of Systemic Risk
Systemic risk arises because financial institutions are highly interconnected. Some key channels include:
Interbank lending: Failure of one bank can cascade to others through unpaid loans.
Counterparty risk: Default by one institution affects those engaged in contracts with it.
Asset fire sales: Banks under stress may sell assets rapidly, reducing market prices and harming others.
Confidence effects: Panic can spread among investors and depositors, causing widespread withdrawals.
The Relationship between Moral Hazard and Systemic Risk
Moral hazard and systemic risk are closely linked.
Moral hazard increases the likelihood of risky behaviour.
Systemic risk magnifies the impact of that behaviour, making failure more dangerous.
Together, they create a cycle where risky behaviour raises the chance of systemic collapse, while the expectation of government rescue fosters even greater risk-taking.
Example Mechanisms
When banks believe they will be bailed out, they engage in higher-risk lending. If one bank fails, others connected through lending or asset holdings also face losses, leading to system-wide instability.
This pattern was evident during the 2007–2008 Global Financial Crisis, where excessive mortgage lending and interconnected financial institutions spread collapse throughout the global economy.
Impact on the Real Economy
Problems in financial markets do not remain confined to the financial system. They spill over into the real economy, harming households, firms, and governments.
Channels of Impact
Credit contraction: When banks reduce lending, businesses and consumers find it harder to borrow, limiting investment and consumption.
Unemployment: As businesses cut back due to reduced credit, job losses rise.
Falling incomes: Households suffer from reduced access to loans and higher uncertainty.
Reduced investment: Investors retreat from risky ventures, limiting economic growth.
Government intervention costs: Bailouts increase public debt, potentially requiring higher taxation or spending cuts.
Preventing and Mitigating Risks
Financial regulation plays a central role in limiting both moral hazard and systemic risk. Measures include:
Limiting Moral Hazard
Stricter lending standards to discourage reckless risk-taking.
Clawback provisions on executive pay to discourage short-termism.
Credible threat of no bailout policies, reducing expectations of rescue.
Limiting Systemic Risk
Capital adequacy ratios: Ensuring banks hold sufficient equity to absorb losses.
Liquidity ratios: Preventing excessive maturity mismatch between short-term borrowing and long-term lending.
Stress testing: Simulating economic shocks to test bank resilience.
Ring-fencing: Separating retail banking from riskier investment banking activities.
Interplay with Financial Stability
Maintaining financial stability requires tackling both moral hazard and systemic risk simultaneously. Over-regulation may limit credit supply, while under-regulation increases the probability of crises. Striking the right balance is central to effective economic policy.
FAQ
Idiosyncratic risk refers to risks that affect a single firm or sector, such as poor management decisions or product failures. These risks are isolated and do not threaten the broader financial system.
Systemic risk, however, is economy-wide and arises when the distress of one institution spreads, often due to interbank lending or asset linkages. Unlike idiosyncratic risk, systemic risk has the potential to destabilise the entire economy.
Bailouts reduce the consequences of risky behaviour by guaranteeing that institutions will be rescued if they fail. This weakens the discipline of the market.
As a result, financial institutions may take on excessive leverage or risky lending, confident that the government will intervene. The expectation of protection undermines incentives for caution.
Moral hazard is not limited to banks. Households can also take on greater risks if they expect someone else to bear the costs.
For example:
Borrowers may take out loans they cannot afford if they believe debt relief is likely.
Insurance policies can encourage reckless behaviour, such as homeowners neglecting fire safety if damage is insured.
Transparency ensures that risks are properly understood and priced. When institutions disclose their exposures and financial positions clearly, contagion effects are less severe.
Without transparency, uncertainty fuels panic. Investors and depositors may withdraw funds unnecessarily, escalating a small shock into a systemic crisis. Transparency builds confidence and prevents fear-driven runs.
Yes, systemic risk can also arise in non-bank financial institutions, such as insurance companies, hedge funds, or shadow banks.
These entities are connected to traditional banks through investment portfolios, derivative contracts, and credit markets. If a large non-bank institution fails, the ripple effects can trigger wider instability across the financial system.
Practice Questions
Explain what is meant by the term systemic risk in financial markets. (3 marks)
1 mark for identifying systemic risk as the risk of collapse spreading through the financial system.
1 mark for reference to interconnectedness of financial institutions.
1 mark for linking this to the potential for widespread financial instability or collapse.
Discuss how moral hazard in banking can increase the likelihood of systemic risk in the financial system. (6 marks)
Up to 2 marks for defining or explaining moral hazard (e.g., risk-taking due to protection from losses).
Up to 2 marks for explaining systemic risk (e.g., failure spreading due to interconnectedness).
Up to 2 marks for analysis linking the two concepts (e.g., banks taking greater risks expecting bailouts, making a collapse more likely to spread through the system).
Credit well-developed examples such as the 2007–2008 Global Financial Crisis.
