Question

Define and discuss each of the following: the moral hazard problem and the law of diminishing control. Provide an example of the moral hazard problem from the 2008 financial crisis.

Answer 1

Moral hazard problem occurs when person indulges in more risk once being insured knowingly that the cost will be beared by someone else. The borrowers generally indulge in high risk not liked by lender in order to not pay back the loan or pay less.

Law of diminishing control states that the institutions or firms which are to be regulated advice or suggest regulatory authority on how to overcome the regulations.

Example of moral hazard: In financial crisis 2008, financial institutions well off knew that they are being protected by the goverment so they granted heavy loans to consumers or businessmen. Loan takers knew that if any mishap occurs financial institutions are protected by the governmnent or the regulatory authority. As a result, financial institutions were not able to bear the cost of risk which lead to the crisis.