Principle Agent Moral Hazard
How did events leading up to the Great Recession illustrate the significance of the Moral Hazard and/or the Principal-Agent problem? Give an example from a news article to illustrate. What could be done to minimize such problems?
Answer.
We referred to the article given at http://www.cato.org/policy-report/januaryfebruary-2010/perfect-storm-ignorance
The root cause of everything that led to the great recession of 2008 can be traced to the Sub-prime Loan crisis. The riskier loans were exposed and the asset prices were over inflated. The major issue was that the commercial banks overinvested in such mortgage backed securities.
Another part of the story is that Basel I accords are credited with giving seeds to the idea of all things that could lead to recession and Basel II is credited with magnifying its impact.
Formed in 1988 and adopted by 1992, Basel I accords were a set of rules and regulations, to be adopted by G-10 countries, that allotted different risk ratings to various types of assets held by banks. Assets, here, referred to bonds, mortgages fund etc.
It took a long time for the economies to realise the problems associated with such types of system. For example, in such a framework a commercial bank was permitted to keep aside no liquid capital if it had all government bonds or gold as assets. This was so because such assets were considered safe. Further, it was required of them to keep aside small percentages of capital for every mortgage, commercial loan or bonds they issued.
With the introduction of Basel 2, the list was expanded to bonds backed by debts like car or property loans and yet had to keep only a 2 percent of spare capital. Flip side to this was that the bonds ought to have AA or AAA credit ratings from the government.
Statistics tell that just prior to the recession, 81 percent of all Mortgage backed securities held by the commercial banks had AAA credit rating. Further, 93 percent of all mortgage-backed
Answer.
We referred to the article given at http://www.cato.org/policy-report/januaryfebruary-2010/perfect-storm-ignorance
The root cause of everything that led to the great recession of 2008 can be traced to the Sub-prime Loan crisis. The riskier loans were exposed and the asset prices were over inflated. The major issue was that the commercial banks overinvested in such mortgage backed securities.
Another part of the story is that Basel I accords are credited with giving seeds to the idea of all things that could lead to recession and Basel II is credited with magnifying its impact.
Formed in 1988 and adopted by 1992, Basel I accords were a set of rules and regulations, to be adopted by G-10 countries, that allotted different risk ratings to various types of assets held by banks. Assets, here, referred to bonds, mortgages fund etc.
It took a long time for the economies to realise the problems associated with such types of system. For example, in such a framework a commercial bank was permitted to keep aside no liquid capital if it had all government bonds or gold as assets. This was so because such assets were considered safe. Further, it was required of them to keep aside small percentages of capital for every mortgage, commercial loan or bonds they issued.
With the introduction of Basel 2, the list was expanded to bonds backed by debts like car or property loans and yet had to keep only a 2 percent of spare capital. Flip side to this was that the bonds ought to have AA or AAA credit ratings from the government.
Statistics tell that just prior to the recession, 81 percent of all Mortgage backed securities held by the commercial banks had AAA credit rating. Further, 93 percent of all mortgage-backed