Too big to fail versus moral hazard

By Henry C K Liu

"Too big to fail" is the cancer of moral hazard in the financial system. Moral hazard is a term used in banking circles to describe the tendency of bankers to make bad loans based on an expectation that the lender of last resort, either the Federal Reserve domestically or the International Monetary Fund globally, will bail out troubled banks.

Barely 48 hours after US Treasury Secretary Henry Paulson declared his firm commitment against the danger of "moral hazard" by promising that no more taxpayer money would be used to bail-out failing financial firms on Wall Street except in extreme situations, US authorities succumbed to the "too big to fail" syndrome in the case of American International Group Inc (AIG), the giant global insurance conglomerate founded in Shanghai in 1919. Paulson's moral hazard aversion had prevented Lehman Brothers Inc, the country's fourth-largest investment bank, from getting a government bailout. Without a needed government guarantee to limit the exposure of potential buyers, Lehman was forced to file bankruptcy protection at midnight on Sunday, September 14.