The risk of moral hazard increases when capital levels are low.

Question

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When capital levels are low, a financial institution may feel more inclined to take on risky investment strategies in order to generate higher returns and replenish its capital. However, this creates a potential for moral hazard, as the institution may be motivated to take excessive risks knowing that they can "socialize" the losses if things go wrong (i.e., rely on government bailouts or other forms of support). In other words, low capital levels increase the incentives for a financial institution to engage in risky behavior, which in turn increases the likelihood of moral hazard.

The Risk of Moral Hazard Increases When Capital Levels Are