The contradictions of state regulation of the banking sector: the challenge of moral hazard during the sub-prime mortgage crisis

Abstract

The sub-prime crisis began in mid-2007 as a bursting of the US housing market bubble and became a truly global meltdown in 2008. Renewed instability in financial markets precipitated awareness of how policy makers must react to systemic failures. This paper discusses the primary policy issues raised by the Federal Reserve/Treasury intervention in order to contribute to the ongoing debate on crisis management and moral hazard. It argues that the guarantee of government rescue did not lead to a moral hazard embodied by the sub-prime crisis. Instead, the opposite took place – government failure to regulate highly leveraged institutions in the time period prior to the crisis created conditions that would lead to a perfect storm of financial collapse. In investigating the regulatory as well as market sources of the 2007 credit crunch, this paper describes the steps that policy makers must take to preempt systemic failures as an alternative to reliance on the Federal Reserve stepping in after a crisis breaks out.