The unwinding of the financial meltdown revived the specter of “too big to
fail.” Under this doctrine, some major financial institutions are considered so
important to the economic health of the financial system that the government
will not allow them to fail. With few exceptions, most notably Penn Square Bank
in 1982 and Lehman Brothers in 2008, the government has stepped in to res-
cue major financial firms when their failure would pose widespread systematic
risks to financial markets. But the expectation of government financial backing
or bailout invokes two types of moral hazard. It may induce some banks and
financial institutions to take excessive risks, increasing the chance of insolven-
cies—the very disasters that intervention seeks to prevent. This is one type of
moral hazard. The regulatory body itself is prone to a second type of moral haz-
ard. Before the fact, it professes to offer limited guarantees, intervention, and
assistance But after the fact (in the event of a failure), it has a strong incentive
to bend the rules and offer full money infusions and bailouts to minimize the
wider financial repercussions of large institutional failures.^11
The aftermath of the financial crisis brought new regulation of the financial
industry, known as the Dodd-Frank Act. One part of the new law requires origi-
nators to retain a percentage of the loans they make to better incentivize them to
scrutinize loan recipients. Another part of the law designates major institutions to
be labeled as “systemically significant” (too big to fail), subjecting them to
increased capital requirements, additional regulation, and a strict resolution
process should they encounter severe financial problems. Interestingly, one of the
regulations would allow the government to “claw back” two years of executive com-
pensation of any senior executive responsible for the failure of one of these insti-
tutions. The jury is still out on the potential impact of these evolving regulations.^12PAYING FOR RESULTS As the previous contracting, medical, and financial
examples show, the potential for moral hazard is inherent in a host of settings.
However, frequently the problem can be mitigated by paying careful attention
to incentives. For instance, the norm for most professional services providers—
law firms or advertising agencies—is to charge for their services on an hourly
basis. Principal-agent theory predicts that “you get what you pay for”—in this592 Chapter 14 Asymmetric Information and Organizational Design(^11) In the United States, periods of financial instability are not new. During the Great Depression,
banks experienced frequent “runs”—frenzied withdrawals by depositors. In response, government
agencies, namely, the Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and
Loan Insurance Corporation (FSLIC), insured bank deposits against defaults in return for annual
premiums paid by participating banks. This insurance (though only partial) served to boost pub-
lic confidence in banks during troubled financial times. However, deposit insurance creates its
own moral hazard problems. In the savings and loan crisis of the 1980s, overly aggressive bank
managers generated high-risk, high-return loan portfolios, against the backstop of insured deposits.
For a discussion, see P. A. Meyer, Money, Financial Institutions, and the Economy(Chicago, Irwin
Publishing, 1985), Chapter 15.
(^12) For views on financial reform, see A. R. Sorkin, “Dodd-Frank Dissenters Sound Off,” The New
York Times, May 10, 2011, p. B1; and S. M. Davidoff, “In F.D.I.C.’s Proposal, Incentive for Excess Risk
Remains,” The New York Times, April 12, 2011, p. B9.
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