In financial markets the mechanism for avoiding moral hazard is a bit different, but the principle is the same. The key is to make sure that those who are making the decisions about how to invest other people’s money face consequences if they make bad investments. If the government simply bails out too big to fail firms and makes them whole again whenever they take too much risk, the individuals won’t face large consequences for their actions and they will have no incentive to attenuate their risky behavior.The Dodd-Frank financial reform law, enacted in 2010, attempted to solve this problem by giving regulators what is known as “resolution authority.\” Under this authority, large, systemically important banks must have plans drawn up in advance for an orderly resolution should they get in trouble. Thus, unlike in the past these banks will not be saved if they are in danger of failing. Instead, the orderly resolution plans will be executed, the banks will be allowed to fail and the bank managers who made the decisions that led to the trouble will be out of a job.There is some question about whether the government will have the will to exercise this power when a giant bank is in trouble — what if the orderly resolution plans don\’t work after all? But bank executives certainly face larger personal risks today from taking on excessively risky investments than they did in the past.
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