Question

Congress passed TARP in 2008 to try to save the financial institutions that were adversely affected by the crisis.

However, the process of the government “bailing out” a business is subject to much debate.

Is the moral hazard that was created when the federal government bailed out those firms that made bad investment decisions benefiting those firms and, in effect, penalizing firms who played by the rules?

Do some firms make risky investments knowing that they are “too big to fail” and that, therefore, the government will step in and save them?

Answer 1

Yes, the moral hazard in this case would be the fact that firms that are not risk averse and would be eventually bailed out by the government feel like they don't have enough incentives to guard against the risks of bad investment decisions. Hence, from the next time onwards such firms are more likely to take more risks putting the government liable while risk- averse firms who are likely to play by the rules would suffer financial stress.

Yes, certain firms know that the government would not risk threatening global stability and would eventually bail-out such firms in times of risky investments not paying off. This is a definite moral hazard. Thus , stakeholders in these firms knew of outcomes where their firms would not likely bear the full costs of the firm taking risks and take more risks.