A moral hazard is simply defined as a risk that a financial institution or a party to a contract enters into a contract not in good faith. A party to a transaction can decide to provide false information regarding its assets, liabilities or financial status in order to earn a profit before the contract is settled. According to Madura, a moral hazard arises when insured banks whose depositors are protected are willing to take on more risk in terms of giving out loans (483). Financial institutions can use moral hazards to get out of trouble. In this case, the bank or the financial institution would seek to maximize returns by use of high-risk loans with the assumption that in case of problems, they will be bailed out (Madura 634).
Moral hazards have created a host of problems, the most recent being the biggest financial crisis in 2009/2010. Most governments and financial markets regulators have come up with ways to reduce moral hazards in economies. Among the efforts to counter moral hazard problem is the Dodd-Frank Wall Street Reform and Consumer Protection Act. The main aim of this bill is to enhance restoration of accountability and responsibility for the Wall Street and other big banks in U.S. It also aims at stabilizing the economy, enhance creation of jobs and in effect avoid financial crises in future.
Moral hazard in this bill is addressed in several ways. First, a watchdog affiliated to the Federal Reserve is to formed and charged with the responsibility of ensuring that consumers in the U.S. have access to timely and accurate information regarding financial products. The consumers are therefore protected from undisclosed fees and other charges, unfair terms of financial products and cheating. The bill addresses moral hazard by eliminating the possibility of taxpayers bailing out a financial institution. The federal reserve has done this by ensuring that there are rigorous standards in place that regulate banks, ensuring there are safe ways to liquidate financial institutions that face financial problems without attempting to bail them out and putting new capital and liquidity measures in place for banks and financial institutions.
Another way in which moral hazard has been dealt with in the bill is through formulation of a system to monitor and detect risks of financial institutions before they get out of hand. The bill also establishes a system where shareholders have the final say on critical issues such as the pay of directors and severance agreements in financial institutions. The investors are also protected by the bill through enforcement of rules that provide transparency and accountability for agencies who rate credit instruments. Financial regulators and overseers are now empowered to scrutinize books of accounts carefully in order to identify fraud, conflicts of interest and system manipulation. This is another critical way of dealing with moral hazard.
The bill also seeks to reform the Federal Reserve in order to enable it reduce moral hazard in financial institutions. The bill creates a limit of emergency lending by the Federal Reserve to banks and other financial institutions. It also provides that the Government Audit Office (GAO) should conduct audits of all Federal Reserve emergencies lending to banks and other financial institutions. This should be done regularly in order to detect and deal with moral hazards as early as possible. Other reforms include reforms on governance of the Federal Reserve, nomination and appointment of the president of the Federal Reserve and limitations on guarantees of banks by the Federal Reserve.
The bill also seeks to improve the protection of minority rights such as the rights of women. The Office of Minority and Women Inclusion ensures that there is diversity in contracting and employment in the economy. This therefore ensures that the minority participate in regulation of financial institutions. Mortgage reform is also included in the bill and it aims at ensuring that unfair lending practices are eliminated and that the lender satisfies himself of borrower’s ability to pay before completing the contract. These measures will reduce moral hazard by a very large extend (Dodd-Frank 3).
This bill is effective to deal with moral hazards in the U.S. economy and the global economy at large. This is because the consumer financial watchdog and the financial stability oversight council established are strong and professionally established. These two bodies formed by the bill have the necessary powers and support from the Federal Reserve to carry out their duties hence the bill would be effective in addressing moral hazards. The membership of the councils established is drawn from the Federal Reserve, Financial institutions and independent bodies. Therefore, there is no conflict of interest hence effectiveness of the bill.
I believe that the bill is effective and if well implemented and enforced, it will be effective in averting financial crises in the future. I would however change a few things about the bill. First, I would widen the range of experts who compose the consumer protection watchdog and other councils to include more experts such as anti-money launders, real estate developers and other key players in the economy. I would also make the consumer protection watchdog and other bodies established by the bill more autonomous to increase their efficiency to deal with moral hazards.
Works Cited
Dodd-Frank. Brief Summary Of The Dodd-Frank Wall Street Reform And Consumer Protection Act. n.d. Web.
Madura, Jeff. Financial Markets and Institutions. Ohio: Cengage Learning, 2009. Print.