Assignment on Moral Hazard insurance arrangement

A moral hazard in an insurance arrangement is a situation that occurs due to one party getting engaged in a risky venture or knowingly fails to act in good faith, because they know that in case of any loss, the other party has to bear it.

Example of Moral Hazard insurance arrangement

A driver who has purchased an insurance policy for his vehicle, and the terms of the insurance includes, full coverage, accident forgiveness, and no deductible may, will be exercising less care while driving as compared to a person who has a less generous policy of insurance, because the first driver knows that in case of any mishap, it would be the insurance company that has to pay.

Adverse Selection of Moral Hazard insurance arrangement

Adverse selection is a situation that occurs when a buyer has more information than the seller, about a transaction. In case of insurance companies, this scenario occurs when the insurance companies are not aware of the risk of a potential loss, connected to the item, because the buyer has not disclosed it to them.

Example: An example of it would be that, when a driver who drives a racing car, or a person who works with explosive material buys an insurance policy, and the insurance company is not aware of the fact, that the person has a risky occupation.

Answer no 2: It would be a case of adverse selection owing to the reason that people who can burn their properties for a personal gain or benefit, would willingly buy sizeable fire insurance policies. Moral hazard could also be problematic, because a person who has bought a fire insurance policy would not get much benefit for taking measures to prevent a fire.

Answer no 3: The creation of the FDIC makes a contribution to the economic growth in the way that it encourages the depositors to deposit their money into the banking system. The reason is that, when the funds are deposited at the financial intermediaries by the savers, these institutions make sure that those deposited funds will be used for the best possible purpose. This efficient allocation of resources that are scarce, contributes to the growth of the whole economy and is beneficial for the whole economy it means that investment is made in only those ventures that are productive.

Answer no 4: It would be better for you if the purchase and assumption method is used by the FDIC, in case you have deposited $300,000 at a failed bank. By this way, the bank would never be closed and not a penny would be lost by you. If the method that was used was of payoff, you would receive a check of $250,000 and then to get the 90 cents per dollar of the remaining $50,000 you will have to wait for a few years. You would be indifferent as to the method that the FDIC would use in handling this failed bank if your bank balance was $200,000.

Answer no 5: The bank panics get less likely to occur in the case of a too-big-to-fail policy, and it is the benefit of this policy. The costs that are associated with it are that the incentives of moral hazard by the big banks, who are aware of the fact that the depositors do not have any means of tracking the bank’s risk-taking policies. Also, additionally, this policy is not fair because it discriminates against the small banks.

Answer no 6: Because the activities that are off-balance sheet are not written on the bank balance sheets, so by simple bank capital requirements they cannot be dealt, which are based on assets of the bank, leverage ratio is an example. The regulators of bank have dealt with this problem, by the imposition of an additional risk-based requirement of bank capital that banks set aside additional bank capital requirement for the different types of activities that are off-balance sheet.

Answer no 7: In a country that has institutions that are not very strong, where corruption is prevalent and regulations of the financial sector are ineffective, a system of deposit insurance would not be recommended by you for such a country. The main reason for not recommending it is that though by adopting it the problem of bank runs would be solved but at the same time it creates the moral hazard incentives for banks to engage in risky lending. It would require strong institutions, stringent financial regulations and supervision for decreasing the moral hazard incentives for risky lending.

Answer no 8: Bank examinations are involved in bank supervisions, in which six areas of the bank are represented in the CAMELS rating (capital adequacy, asset quality, earnings, liquidity, and sensitivity to market risk) are assessed by the examiners. A “problem bank” would be declared by the supervisors as the one with a low score on CAMELS ratings that would make it more subjected to frequent examinations and also to sanctions to reduce the amount of risk taking that is involved in it. It is also checked by the examiners of the bank that if the bank is holding securities or loans that involve too much risk and if the bank is following the rules and regulations. All of these measures help in ensuring that the bank is not taking much risk and it is in a safe area, and so a safer and sounder system of banking is promoted in this way.

Answer no 9: By giving it permission to make more borrowings from the Treasury and by raising insurance premiums, the Bank Insurance Fund of the FDIC was recapitalized. By putting a limit on the brokered deposits and by also establishing a limit on the too-big-to-fail doctrine by forcing the FDIC to use the least cost method of closing failed banks except under the circumstances that are unusual, the bill reduced the scope of deposit insurance. The bill contains a prompt corrective action provision that requires an earlier intervening by the FDIC, with actions that are stronger when banks move into the weaker of the five classifications based on the capital of the bank. The reduction of moral hazard risk-taking on the part of the banks would be reduced by limiting of the deposit insurance and by taking prompt corrective actions. The FDIC is instructed by the bill to come up with premiums that are risk based, and that will be the cause of increasing the premium cost when more risk is taken on by the banks, thus helping in reducing the problem of moral hazard. Increased requirement of reporting and annual examinations to prevent the banks from taking on too much of risk is also mandated by the bill. The regulations of foreign banks that are operating in the US are also regulated by it; it would restrain them from operating in the US in case they are taking a risk that is too much.

Answer no 10: A bank that is perfectly healthy at a particular point in time can become insolvent at a very fast pace from risky trading in these instruments, with the advent of new financial instruments. A focus on bank capital at one point in time may not be as effective in giving an indication that whether a bank will be taking on risk that is excessive in the near future. In order to make sure that, not too much risk is taken up by banks; the supervisors of the banks are now focusing on risk management procedures in checking whether they are keeping the banks from taking risks that are excessive, so that a future failure of bank becomes less likely.

Answer no 11: It would be a financial catastrophe, if a bank that holds 70% of all of the deposits in the US, fails. To prevent this institution from leading to bankruptcy, we can expect that the FDIC or any other competent office would do anything. Due to the constant merging of banks, this is particularly the type of problem that the regulators would are likely to face in the future. To deal with the problem of huge financial institutions and the potential negative effects that would be on the economy, is actually a real challenge for the actual and future financial regulators.

Answer no 12: It is made sure by consumer protection regulations generally that all the information that is relevant is disclosed to the potential borrowers, and the discrimination against lenders is forbidden. To comply with these regulations is costly for the financial intermediaries, and therefore it impacts their profits negatively. The financial intermediaries might attract more potential customers that will now have a fair chance of getting a loan and to understand its conditions thoroughly, by disclosing the information and not discriminating.

Answer no 13: Generally, yes. Decreasing the possibility of a failure, a national banking system will make the banks able to diversify their loan portfolios better. Additionally, it will result in making efficient the banks and the economy as- well, and also helps in increasing the profitability of the banks, that will make them healthier.

Answer no 14: From the reduced moral hazard the economy would take benefit, that is the banks would avoid taking excessive risks, because in doing so their deposit insurance premiums would be increased. However, the problem is that, monitoring the degree of risks faced by the banks is difficult because very often the banks that are making the loans know about the real risk situation.

Answer no 15: By the lobbyist of the financial industry, the Dodd-Frank Act of 2010 was vigorously fought. Against the actions of the Wall Street and the consequences it had on the economy overall, the legislative branch had to be answerable to the citizen’s clamor. After a year of discussions and changes in the original bill the result was in the form of Dodd-Frank Act 2010, as a consequence. The new financial regulations increase the costs for the financial institutions and so reduces the profits, was the argument of the lobbyist of the financial industry.