Over the past several years, the federal government has rescued a few financially distressed banks and other large private companies, and the key reasons for these actions is to stabilize financial markets and to prevent additional business failures that may arise from the original problem. However, critics of these interventions argue that these actions generate a moral hazard problem. Why?
A) Government oversight of rescued firms is typically based on limited information, so the outcome is economically inefficient.
B) Rescued firms will have a difficult time buying insurance in private markets, so the government will also have to insure the firm against losses from fire, theft, etc.
C) Managers have more information about the financial strength of their firm than government officials, so the rescue attempts may be unnecessary.
D) Managers may be more likely to invest in risky projects if they believe the government will save the firm in case of failure.

Question

Quizplus · Accepted Answer

Critics argue that by bailing out firms that are too big to fail, the government creates a moral hazard problem by essentially signaling to these firms that they will be rescued in times of distress. This may lead managers to take on excessive risks and invest in risky projects, knowing that the government will come to their rescue in case of failure.

Over the Past Several Years, the Federal Government Has Rescued