Financial crises and moral hazard

Pierre Magnussen

Student thesis: Master thesis


Financial crises are currently the main topic of interest for many economists and due to the current international financial distress also a focal point for ordinary people. Everyone is affected by financial crises and the attempts to restore an economic equilibrium are followed with interest by a majority of people. Why financial crises occur and how to prevent them has been of major concern in the past, the factor and phenomenon of moral hazard has been presented as being of major importance and institutions that may enhance moral hazard have been in focus and been subject to substantial criticisms. This thesis seeks to assess and define major implications of moral hazard and how it is conceptualized in the context of financial crises. Because moral hazard is a probabilistic concept, centred on forwardlooking behaviour it is both difficult to measure and also to fully understand. A theoretical analysis of the phenomenon is therefore conducted in the thesis in order to fully understand the concept and its deeper meanings and implications. The theoretical analysis starts with an introduction of the principalagent theory and how the contractual relationship between the two parties can affect outputs and incentives. A historical background of use of moral hazard is presented and how its meaning and implications has shifted through time. The theoretical analysis eventually concludes that moral hazard is related to skewed incentives and it occurs when a risk decision is asymmetric. With regards to financial crises it is necessary to look at institutions that can affect incentives and risk parameters in an international concept. The lender of last resort is the broad term for such an institution and the thesis shows that the International Monetary Fund (IMF) can be classified as such. It is concluded through the theoretical analyses that the lender of last resort theoretically can alter risk-incentives and thereby affects the level of moral hazard. To determine if the IMF in reality has an impact on moral hazard in the context of financial crises and empirical analysis is carried out. The analysis is conducted through an event-analysis that focuses on announcements and actions taken by the IMF and its impact on bond spreads. The crises that are included in the in the analysis are: the Mexican crisis in 1994, the East Asian crisis in 1997 and the Russian crisis in 1998. Although the findings are diverse and to some extent inconsistent with regards to the role of the IMF in enhancing moral hazard, it is concluded that the IMF to some extent has a negative impact on moral hazard in the sense that its actions some times increases the risk of moral hazard. Furthermore it is concluded that moral hazard always will persist in the context of financial crises though it is plausibly a better outcome to operate with some degree of moral hazard compared to not having institutions like the IMF and its insurance at all.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2009
Number of pages167