Financial Risk Manager Part 1
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Q.432 During periods of economic downturn, governments often weigh the option of bailing out financial institutions to prevent a complete collapse of the economy. Nonetheless, this approach is not without its pitfalls. What is the principal challenge associated with the bailout of institutions during economic crises?
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TTanishq
A
It necessitates a significant write-off of toxic assets.
B
It amplifies the issue of adverse selection in financial markets.
C
It may instigate widespread public dissent or potentially disastrous protests.
D
It exacerbates the problem of moral hazard within financial institutions.
Explanation:
The primary issue with bailing out institutions during economic crises is that it increases the problem of moral hazard. Moral hazard refers to a situation where an entity is more likely to take risks because the costs that could result will not be borne by the entity taking the risk. In the context of financial institutions, if they are aware that they will be bailed out in times of crisis, they may engage in riskier behavior, knowing that they will not bear the full brunt of the negative consequences of their actions. This can lead to a cycle of risky behavior and bailouts, which can have detrimental effects on the economy. The government's decision to bail out certain institutions during the 2007-2009 financial crisis, such as AIG, Freddie Mac, and Fannie Mae, may have inadvertently encouraged this kind of behavior.
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