It is indeed true that the U.S government treated some financial institutions differently during the crisis. Evidence from the case study suggests that this was actually the case. For instance, the government had bailed out both Fannie Mae and Freddie Mac just a week before Lehman was simply left to fail. There was also the case of the government extending an $ 85 billion loan to AIG calculated to prevent the failure of the insurance conglomerate.
Whether the differential treatment of financial institutions was appropriate
I think it was inappropriate for the U.S government to follow this approach of differentially bailing out some financial institutions while letting others to just fail. Such treatment is a reflection of how politics, as opposed to the need for macro prudential management, was at the centre of regulating systemic risk in the financial sector. Both Fannie Mae and Freddie Mac were private financial institutions but with broad political support which made their bailouts more politically acceptable. This same influence of politics was also visible in the negotiations to bail out AIG. It was only when it appeared politically convenient that efforts to bail out Lehman were abandoned.
I totally agree with the assertion that bailing out private financial institutions crates the problem of moral hazard. The assertion is a clear demonstration that the idea concept of efficient market hypothesis (EMH) is fundamentally flawed. Conventional finance had long held to the notion that markets are rational. Evidence has, however, shown that this assertion is not borne out in practice and that human behavioral factors have important implications in finance. Moral hazard is just one of these behavioral factors. It proceeds from the precept that individuals or institutions act on the basis of incentives. In the context of financial institutions, there is a strong incentive to engage in risky behavior if doing some would amount to more profits. The institution gets all the advantages that flow from the risk taking behavior while bail outs ensure that other people shoulder the disadvantages.
The 2008 financial crisis was clear evidence that bail outs create moral hazard problems. The problem is, however, not attributed to a certain group of people in the financial system. In the case of sub prime borrowers, the problem arose from the fact that one could simply walk away from a property whose mortgage repayments exceeded equity in the property. Executives and shareholders in many financial institutions had the incentive to take on more risks as this held the prospect for higher returns.
Yes, I think the U.S government should have allowed Lehman to fail just as it actually did. Allowing Lehman to fail was justified in several respects. First, it provided an opportunity to take another look at the regulation of financial institutions in the U.S. Decades of deregulation had culminated in the blurring of the distinction between commercial banking on the one hand and investment banking on the other. Allowing Lehman to fail offered an opportunity to evaluate whether that distinction was necessary. The enactment of the Dodd-Frank Act is a sign that such a distinction was actually necessary. Secondly, the failure of Lehman was a necessary step to force the institution to internalize its negative market externalities. It was necessary for the common stockholders of the firm to take responsibility for the risks their encouraged the firm to take.
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