Too Big to Fail, Too Bold to Care: The Moral Hazard Behind Bank Bailouts

 

 

 

Major banks sometimes take unbridled risks at the taxpayers’ expense. Why, you may ask? Well, would you go skydiving without a parachute? No, right? It’s the same principle with banks: they take risks that could spark adverse effects because they know there’s a safety net (government and taxpayers) to protect them- even if it is to everyone else’s detriment.

Imagine you’re in a group project where everyone wants a decent grade, but one member, Sonny,  contributes little, shows up late, and submits their work past the deadline (if any at all!). Thankfully, the rest of the group picks up the slack despite Sonny’s priorities being elsewhere. This scenario portrays the principal-agent problem: the group (principal) aims to achieve a first with equal group participation, but Sonny (the agent) has conflicting incentives that clash with the group’s objectives. Mctigue, Monios, and Rye (2020) highlight how such mismatches hinder collective goals, capturing the core of the principal-agent problem.

This same type of conflict occurred on a massive scale during the 2008 financial crisis. The government (principal) trusted bank executives (agents) to manage loans and investments responsibly. Instead, bankers were enticed by the opportunity for hefty bonuses and issued too many risky mortgages, often to people who couldn’t repay them. Former CCO of Fannie Mae estimated that by early 2008 there were 27 million higher-risk subprime mortgages with an outstanding value of $4.6 trillion (Wallison & Burns, 2011). These flimsy loans were packaged into complex financial products and traded globally, spreading the risk throughout the financial system. When borrowers inevitably began defaulting, it caused banks to collapse and ignited a worldwide economic meltdown. This misalignment between the government’s goal of financial stability and the bankers’ pursuit of profits is a prime example of the principal-agent problem, ultimately leading to significant economic damage (Gietl & Kassner, 2020).

Here’s another scenario! Sonny is at a casino playing Blackjack. He has a strong hand but is at a disadvantage as he doesn’t know the dealers’ hidden card. Undeterred by the uncertainty, Sonny bets recklessly, going ‘all in’, believing he’ll win. He ignores the risks because he thinks that he can handle the losses, or worse still, he believes the casino may be nice enough to cover his losses! (We warned you that Sonny isn't the brightest!). This parallels bankers’ behaviour before a bailout.

They bet boldly on risky assets expecting high returns without fully considering the consequences- just like Sonny, who didn’t account for the unknown card, bankers make reckless gambles without accounting for all financial risks involved. When these assets lead to substantial losses, banks rely on the government to bail them out. Regulators and governments face an asymmetric information problem—they know less about the risk exposure of banks than the banks' executives do. Executives receive extensive bonuses when risky assets pay off and are not significantly affected by losses because of government support. Busuioc and Birau (2011) claim that information asymmetry fuelled the 2008 financial crisis, burdening taxpayers because of banks’ excessive risk exposure.

Now picture Sonny losing most of his money at the casino, then heading to the pub with a near-empty bank account. When his card unavoidably declines, his friend covers the tab. Good for Sonny, right? But now that he knows his friend will cover all losses, what will stop him from entering the pub empty-handed again? This concept of taking risks unnecessarily, knowing someone else will bear the cost of your actions is a classic microeconomic dilemma called ‘moral hazard’, and it plays a huge role in financial bailouts.

The moral hazard phenomenon during the 2008 financial crisis distorted the incentives of financial institutions, as they felt encouraged to take risks knowing they’d be rescued if problems arose (Dowd, 2009, p158). It’s just like how Sonny’s friend, covering his losses, coaxed him into reckless spending! This poses a substantial issue. If governments let banks fail, there would be economic chaos to a colossal degree, much like the ‘Great Recession’ triggered in America as a result of the financial crisis, causing GDP to plunge by 4.3% (Federal Reserve, 2013). But each bailout reinforces to the big banks that they can act impulsively with few consequences. So, what does this mean for the future of bank bailouts?

If bank bailouts become the norm, financial institutions will likely engage in more risk-taking behaviour, knowing that they can rely on government intervention to mitigate their losses - seems like there is such a thing as a ‘free lunch’ after all! This creates a dangerous cycle where bailouts address the immediate crisis but incentivise future risk-taking, ultimately leaving civilians to bear the consequences. Notably, in 2023, Silicon Valley Bank (SVB) faced a severe cash shortage. Despite SVB not being a major global bank, the U.S. government chose to protect all of its depositors. As Tasinato (2023) observes, such interventions send a signal that the safety net extends even beyond “Too Big to Fail” institutions, reinforcing moral hazard. To avoid repeating the same mistakes, we need to rethink how bank bailouts are done.

However, eliminating the government’s role could worsen crises and harm depositors (Jhin, 2023). Moderate solutions like regulatory reforms, conditional bailouts, and orderly bank failures can mitigate moral hazard with minimal downsides. For instance, the Federal Reserve introduced a risk-sensitive capital measure to assess financial vulnerabilities and warn banks (Hirtle & Lehnert, 2014).

Nevertheless, government support for banks shouldn’t be unconditional. During the financial crisis, the U.S. Treasury announced restrictions on compensation and provided guidelines on reducing moral hazard (Cadman, Carter & Lynch, 2012). Thanks to stricter regulations, SVB’s failure didn’t spark another crisis (Power, 2023). After SVB’s collapse, Casey (2024) proposed reforms to reduce moral hazard including independent reviews after bailouts and allowing legal challenges when the system is misused.

There you go! Microeconomic dilemmas are all around us, ranging from lazy partners to reckless bankers. When banks prioritise profits at the expense of everyone else, financial systems unravel. The challenge? Keeping the Sonny’s of the world, and financial institutions, accountable.

 

 

Bibliography:

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McTigue, C., Monios, J. and Rye, T., 2020. The principal-agent problem in contracting public transport provision to private operators: A case study of the UK Quality Contract Scheme. Utilities Policy, 67, p. 101131. https://doi.org/10.1016/j.jup.2020.101131. [Accessed 26 Mar. 2025].

Power, J., 2023. Why did Silicon Valley Bank fail and is a financial crisis next? Al Jazeera, 14 March. [Online]. Available at: https://www.aljazeera.com/economy/2023/3/14/why-did-silicon-valley-bank-fail-and-is-a-financial-crisis-next [Accessed 29 Mar. 2025].

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