Homebuyers think Canada is too big to fail because of its real estate dependence. People perceive it as risk-free since it is too dependent on housing to crash. Whenever a disaster is avoided, the government reinforces the belief that buyers can’t lose money. There aren’t many options, except for supporting higher and higher home prices or crashing the economy. There is no other choice here, which is the definition of moral hazard.
Researchers at the National Bureau of Economic Research (NBER) propose another solution – to let one fail. There is a credible solution to the too-big-to-fail dilemma in the new paper, Let the Toronto Real Estate Worst One Fail: A Credible Solution to the Too-Big-To-Fail Conundrum. Two NYU finance professors argue in the paper that bailouts allow banks to experience moral hazard. Having the entire financial system fail to teach them about risk is not feasible. It would be better for the worst offender to fail every time he tries to send a message.
What Is Moral Hazard?
A moral hazard is created when a risk-taker and a sucker fall in love and have a child together. Someone engages in riskier behavior because they are responsible for someone else. Resignation allows the person to behave in a way that would not otherwise exist.
The driver would be more reckless due to vehicle insurance, for instance. Another example would be a tenured professor who does not devote much time to teaching. The party affected by the altered behavior does not have to face the consequences. It is someone else’s problem. A moral hazard is a result of this arrangement.
Bailouts of Banks Create Moral Hazard
Moral hazard is most famously associated with banks during the Global Financial Crisis (GFC). Governments believe the cost of bailing out all banks exceeds the cost of allowing all banks to fail. Banks know this, which encourages them to take more risks. Before the Great Financial Crisis, when it brought down the global economy, the risk grew and grew. As a result of the bailout, the banks were proven right.
Governments promised to reform these banks after the GFC and bring an end to “too-big-to-fail” banks. The result was stricter loan loss coverage rules for systemically important banks (SIBs). In theory, this means banks face greater risk now, according to NBER researchers. The recent pandemic emphasized that investors and the public don’t see it that way
Researchers are of the opinion that it is not practical to allow all banks to fail. Rather than pay out the ransom, the costs to society would be greater. The government lacks the kind of risk tolerance necessary to prevent this, and banks are aware of this. When a bank receives a bailout, it sees fewer opportunities for loss.