Adverse Selection And Moral Hazard Problems

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Recommended: The euro and its impact

2. Outline the adverse selection and moral hazard problems that existed in the Euro crisis of 2009. (approx. 2 double spaced pages; 10 marks)

Moral Hazard
In 1997, Eurozone rules of Stability Growth Pact has outlined Budgetary Discipline to reduce moral hazard and free riding problem. It required all nations in Eurozone to limit its annual deficit and maintain a stable economic growth. Specially, there isn’t bailout permitted. However, some countries never met the debt rules since the very beginning, while others gradually broke the rules, with incentives to take advantages on the alliances and achieve its own development.【一】8

In particular, these countries and their bank take scale of Euro alliance for granted such that they engaged in excessive borrowing and lending. They thought that the Euro alliance was a huge safety net that is “too big to fail” such that it seemed to be less costly for risk taking. When every Euro nation reckoned and behaved the same way, heavy indebtedness and deep insolvency accumulated into a big crisis. 【二】20

In addition, corruption existed in Euro alliance. The transparency of regulation is doubtful. As I mentioned before, rules breaking had been a consistent issues, but no one was penalized for its offence. Poor monitoring of Euro regulators connived the moral hazard and free-riding problem.

【一】 G. Georgopoulos “euro crisis debt lecture.pdf”. University of Toronto. 04, 2016, ppt8
【二】 G. Georgopoulos “euro crisis debt lecture.pdf”. University of Toronto. 04, 2016, ppt20
Adverse selection

When risk loving investors or investors with poor credit were selected for loans, adverse selection problem takes place.

In case of Euro crisis, risk loving investors tended to take advantages on the other p...

... middle of paper ...

...ced page; 10 marks)
No, abandon capital (safety) in return of profitability is not what regulators desire. Regulators care more about the well-being of banks owner and banking system. As I mentioned before, there is a trade-off between safety and profitability. Holding too less capital will largely increase risk of bank’s debt insolvency. A certain amount of capital is required to serve the bank as a buffer against the potential defaults and crisis. 【c】

【a】Frederics S, Mishikin and Apostolos Serletis. "Chapter 13: Banking and the Management of Financial Institutions " The economics of money, banking and financial market. 5th Canadian. Pearson, 305. Print.
【b】Frederics S, Mishikin and Apostolos Serletis. "Chapter 13: Banking and the Management of Financial Institutions " The economics of money, banking and financial market. 5th Canadian. Pearson, 306. Print.
【c】Ibid

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