How and Why Moral Hazard Has Distorted Financial Regulation

  • Norbert GaillardEmail author
  • Richard J. Michalek
Part of the International Political Economy Series book series (IPES)


This chapter argues that, since the 1980s, moral hazard has encouraged excessive indebtedness and contributed to greater leniency from regulators and financial gatekeepers towards systemic banks. Examining the rise of the “too big to fail” (TBTF) banking behemoths, we question how moral hazard came to dominate banking culture and how the developing financial innovation in and after the 1980s combined with that culture to accelerate the growth and pre-eminence of the mega-bank. We explore how financial gatekeepers—US regulators, credit rating agencies (CRAs), and the Federal Reserve—became “lenient partners” (or “sweeteners”) that enabled and accelerated the growth of the financial services sector. We propose various reforms dealing with TBTF banks, CRAs, US regulators, and the indebtedness of American citizens.


Financial regulation Moral hazard Too big to fail Credit rating agencies Glass-Steagall Federal Reserve Securities and Exchange Commission Debt 



Ted Cohn, Bill Harrington, and Anil Hira


  1. Auletta, Ken. 1985. Power, Greed and Glory on Wall Street: The Fall of the Lehman Brothers. New York Times. February 17.Google Scholar
  2. Bank for International Settlements (BIS). 2009. Stocktaking on the Use of Credit Ratings. Basel Committee on Banking Supervision, Joint Forum. June.Google Scholar
  3. Barth, Mary and Wayne Landsman. 2010. How Did Financial Reporting Contribute to the Financial Crisis? European Accounting Review. 19(3): 399–423.CrossRefGoogle Scholar
  4. Behr, Patrick, Darren J. Kisgen, and Jérôme P. Taillard. 2018. Did Government Regulations Lead to Inflated Credit Ratings? Management Science. 64(3): 1034–1054.Google Scholar
  5. Benmelech, Efraim and Nittai K. Bergman. 2012. Credit Traps, American Economic Review. 102(6): 3004–3032.Google Scholar
  6. Bernanke, Ben S. and Frederic S. Mishkin. 1997. Inflation Targeting: A New Framework for Monetary Policy? Journal of Economic Perspectives. 11(2): 97–116.CrossRefGoogle Scholar
  7. Bernard, G. Wogan. 2009. Update on the Amendments to FAS 140 – Accounting for Transfers of Financial Assets and Repurchase Financing Transactions, available at
  8. Bogle, John C. 2005. The Battle for the Soul of Capitalism. Yale: Yale University Press.Google Scholar
  9. Bogle, John C. 2009. Enough: True Measures of Money, Business, and Life. New York: Wiley.Google Scholar
  10. Bruce, R. Christian. 1998. Fed Approves Citicorp-Travelers Merger Creating World’s Largest Bank Company. BNA’s Banking Report. 71(449).Google Scholar
  11. Carrington, Tim. 1984. U.S. Won’t Let 11 Biggest Banks in Nation Fail. Wall Street Journal. September 20.Google Scholar
  12. Cecchetti, Stephen G. and Enisse Kharroubi. 2015. Why Does Financial Sector Growth Crowd Out Real Economic Growth? BIS Working Paper No. 490.Google Scholar
  13. Cecchetti, Stephen G., Hans Genberg, John Lipsky, and Sushil Wadhwani. 2000. Asset Prices and Central Bank Policy. Geneva Reports on the World Economy 2. Center for Economic Policy Research, London.Google Scholar
  14. Cho, David. 2009. Banks ‘Too Big to Fail’ Have Grown Even Bigger. Washington Post. August 28.Google Scholar
  15. Coffee Jr., John C. 2011. Ratings Reform: The Good, The Bad, and The Ugly, Harvard Business Law Review. 1(1): 795–847.Google Scholar
  16. Cox, Christopher. 2008. Chairman Cox Announces End of Consolidated Supervised Entities Program. September 26, available at
  17. Department of the Treasury. 2008. The Department of the Treasury Blueprint for A Modernized Financial Regulatory Structure. Washington, D.C. March.Google Scholar
  18. Donaldson, William H. 2004. Speech by SEC Chairman: Opening Statement at April 28, 2004 Open Meeting. April 28, available at
  19. Dowd, Kevin and Martin Hutchinson. 2010. Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System. Chichester: Wiley.Google Scholar
  20. Dunsmuir, Lindsay and Ann Saphir. 2017. UPDATE 1 – Fed Chair Nominee Powell Sees No Too-Big-To-Fail Banks. Reuters. November 28, available at
  21. Federal Deposit Insurance Corporation (FDIC). 1997. History of the Eighties: Lessons for the Future, Washington, D.C.: FDIC.Google Scholar
  22. Financial Industry Regulatory Authority (FINRA). 2007. NASD and NYSE Member Regulation Combine to Form the Financial Industry Regulatory Authority – FINRA. News Release. July 30, available at
  23. Flores, Juan H. 2010. Competition in the Underwriting Markets of Sovereign Debt: The Baring Crisis Revisited. Law and Contemporary Problems. 73(4): 129–150.Google Scholar
  24. Gaillard, Norbert J. 2011. A Century of Sovereign Ratings. New York: Springer.Google Scholar
  25. Gaillard, Norbert J. 2016. Coping with Reliance on Credit Ratings. Banking & Financial Services Policy Report. 35(7): 12–21.Google Scholar
  26. Gaillard, Norbert J. 2017. Credible Sovereign Ratings: Beyond Statistics and Regulations. European Business Law Review. 28(1): 5–18.Google Scholar
  27. Gaillard, Norbert J. and William J. Harrington. 2016. Efficient, Commonsense Actions to Foster Accurate Credit Ratings. Capital Markets Law Journal. 11(1): 38–59.CrossRefGoogle Scholar
  28. Gaillard, Norbert J. and Michael W. Waibel. 2018. The Icarus Syndrome: How Credit Rating Agencies Lost their Quasi-Immunity. Southern Methodist University Law Review. 71(4): 1077–1116.Google Scholar
  29. Gay, Gerald D. and Joanne T. Medero. 1996. The Economics of Derivatives Documentation. Journal of Derivatives. 3(4): 78–89. Summer.Google Scholar
  30. Greenwood, Robin and David Scharfstein. 2013. The Growth of Finance. Journal of Economic Perspectives. 27(2): 3–28.CrossRefGoogle Scholar
  31. Hand, John R. M., Robert W. Holthausen, and Richard W. Leftwich. 1992. The Effect of Bond Rating Agency Announcements on Bond and Stock Prices. Journal of Finance. 47(2): 733–752.CrossRefGoogle Scholar
  32. Harries, Brenton W. 1968. Standard & Poor’s Corporation New Policy on Rating Municipal Bonds. Financial Analysts Journal. 24(3): 68–71.CrossRefGoogle Scholar
  33. Harrington, William J. 2013. Letter to Mr. Abe Losice, Securities and Exchange Commission and Mr. Felix Flinterman, European Securities and Market Authority. September 11.Google Scholar
  34. He, Jie (Jack), Jun (QJ) Qian, and Philip E. Strahan. 2012 Are All Ratings Created Equal? The Impact of Issuer Size on The Pricing of Mortgage-Backed Securities. Journal of Finance. 67(6): 2097–2137.CrossRefGoogle Scholar
  35. Helleiner, Eric. 2014. The Status Quo Crisis: Global Financial Governance After the 2008 Financial Meltdown. New York: Oxford University Press.CrossRefGoogle Scholar
  36. Holmes, Douglas R. 2014. Economy of Words: Communicative Imperatives in Central Banks. Chicago: Chicago University Press.Google Scholar
  37. Horvitz, Paul M. 1975. Failures of Large Banks: Implications for Banking Supervision and Deposit Insurance. Journal of Financial and Quantitative Analysis. 10(4): 589–601.CrossRefGoogle Scholar
  38. Humphrey, Thomas M. 1975. The Classical Concept of the Lender of Last Resort. Federal Reserve Bank of Richmond Economic Review. 61: 2–9, January/February.Google Scholar
  39. International Monetary Fund (IMF). 2009. Global Financial Stability Report: Navigating the Financial Challenges Ahead. Washington, D.C.Google Scholar
  40. International Swaps and Derivatives Association (ISDA). 2012. The ISDA Credit Derivatives Determinations Committees. May.Google Scholar
  41. Jiang, John (Xuefeng), Mary Harris Stanford, and Yuan Xie. 2012. Does It Matter Who Pays for Bond Ratings? Historical Evidence. Journal of Financial Economics. 105(3): 607–621.CrossRefGoogle Scholar
  42. JP Morgan. 1991. 1990 Annual Report.Google Scholar
  43. JP Morgan. 1992. 1991 Annual Report.Google Scholar
  44. King, Robert G. and Ross Levine. 1993. Finance and Growth: Schumpeter Might be Right. Quarterly Journal of Economics. 108(3): 717–737.CrossRefGoogle Scholar
  45. Krippner, Greta R. 2007. The Making of US Monetary Policy: Central Bank Transparency and the Neoliberal Dilemma. Theory and Society. 36(6): 477–513.CrossRefGoogle Scholar
  46. Liscio, John. 1987. No Relationship: Top Bankers’ Pay Grows While Profits Lag. Barron’s National Business and Financial Weekly. June 29.Google Scholar
  47. Mason, Joseph R. 2015. Overview and Structure of Financial Supervision and Regulation in the US. Policy Department A: Economic and Scientific Policy, Directorate General for Internal Policies. European Parliament. Brussels, available at
  48. Mayer, Thomas. 1975. Should Large Banks Be Allowed to Fail? Journal of Financial and Quantitative Analysis. 10(4): 603–610.CrossRefGoogle Scholar
  49. Mendales, Richard E. 2009. Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown, and How to Fix It. University of Illinois Law Review. 2009(5): 1359–1415.Google Scholar
  50. Mezza, Alvaro and Kamila Sommer. 2015. A Trillion Dollar Question: What Predicts Student Loan Delinquency Risk? FEDS Notes. October 16.Google Scholar
  51. Mian, Atif and Amir Sufi. 2014. House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again. Chicago: University of Chicago Press.CrossRefGoogle Scholar
  52. Minsky, Hyman P. 1977. The Financial Instability Hypothesis: An Interpretation of Keynes and An Alternative to ‘Standard’ Theory. Nebraska Journal of Economics and Business. 16(1): 5–16.Google Scholar
  53. Moody’s Corporation. 2001. Annual Report 2000.Google Scholar
  54. Moody’s Investors Service. 2003a. Structured Finance Rating Transitions: 1983–2002. January.Google Scholar
  55. Moody’s Investors Service. 2003b. Measuring the Performance of Corporate Bond Ratings. April.Google Scholar
  56. Moody’s Investors Service. 2007. Incorporation of Joint-Default Analysis into Moody’s Bank Rating Methodology. February.Google Scholar
  57. Moody’s Investors Service. 2008. Default & Loss Rates of Structured Finance Securities: 1993–2007. July.Google Scholar
  58. Morgenson, Gretchen. 2009. The Cost of Saving These Whales. New York Times. October 3.Google Scholar
  59. Morgenson, Gretchen and Joshua Rosner. 2011. Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. New York: Times Books.Google Scholar
  60. Murdock, Charles W. 2011. The Dodd-Frank Wall Street Reform and Consumer Protection Act: What Caused the Financial Crisis and Will Dodd-Frank Prevent Future Crises? Southern Methodist University Law Review. 64(4): 1243–1328.Google Scholar
  61. Nakamoto, Michiyo and David Wighton. 2007. Citigroup Chief Says Bullish on Buy-Outs. Financial Times. July 9.Google Scholar
  62. O’Neal, Michael K. 2000. Summary and Analysis of the Gramm-Leach-Bliley Act. Securities Regulation Law Journal. 28(2): 95–126.Google Scholar
  63. Oosterhuis, Paul W. 2005. Check-the-Box Planning in Cross-Border Transactions. Taxes – The Tax Magazine. March: 49–57.Google Scholar
  64. Philippon, Thomas and Ariell Reshef. 2013. An International Look at the Growth of Modern Finance. Journal of Economic Perspectives. 27(2): 73–96.CrossRefGoogle Scholar
  65. Poole, William. 2010. Ending Moral Hazard. Financial Analysts Journal. 66(3): 17–24.CrossRefGoogle Scholar
  66. Rowell, David and Luke B. Connelly. 2012. A History of the Term “Moral Hazard”. Journal of Risk and Insurance. 79(4): 1051–1075.CrossRefGoogle Scholar
  67. Securities and Exchange Commission. 2008. Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies. Washington, D.C. July 8.Google Scholar
  68. Securities and Exchange Commission. 2009. The SEC’s Role Regarding and Oversight of Nationally Recognized Statistical Rating Organizations (NRSROs). Report No. 458. Washington, D.C. August 27.Google Scholar
  69. Securities and Exchange Commission. 2013. Report to Congress – Credit Rating Agency Independence Study. Washington, D.C. November.Google Scholar
  70. Sinclair, Timothy. 2005. The New Masters of Capital. Ithaca: Cornell University Press.Google Scholar
  71. Stigler, George J. 1964. Public Regulation of the Securities Markets. The Business Lawyer. 19(3): 721–753.Google Scholar
  72. Stigler, George J. 1971. The Theory of Economic Regulation. Bell Journal of Economics and Management Science. 2(1): 3–21.CrossRefGoogle Scholar
  73. Stiglitz, Joseph. 2010. Freefall: America, Free Markets, and the Sinking of the World Economy. New York and London: W. W. Norton.Google Scholar
  74. Summers, Larry. 2007. Beware Moral Hazard Fundamentalists. Financial Times. September 23.Google Scholar
  75. Swary, Itzhak. 1986. Stock Market Reaction to Regulatory Action in the Continental Illinois Crisis. Journal of Business. 59(3): 451–473.CrossRefGoogle Scholar
  76. Tett, Gillian. 2009. Fool’s Gold: The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted Its Bold Dream and Created a Financial Catastrophe. New York: Free Press.Google Scholar
  77. U.S. Senate. 2009. Hearing Before the Committee on Banking, Housing, and Urban Affairs, Oversight on the Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978. Washington, D.C. February 24.Google Scholar
  78. U.S. Senate, Permanent Subcommittee on Investigations. 2010. Exhibits – Hearing on Wall Street and the Financial Crisis: The Role of Credit Rating Agencies. Washington, D.C. April 23.Google Scholar
  79. U.S. Senate, Permanent Subcommittee on Investigations. 2011. Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. Washington, D.C. April 13.Google Scholar
  80. Wilmarth Jr., Arthur E. 2002. The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks. University of Illinois Law Review. 2002(2): 215–476.Google Scholar
  81. Wilmarth Jr., Arthur E. 2009. The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis. Connecticut Law Review. 41(4): 963–1050.Google Scholar
  82. Wilmarth Jr., Arthur E. 2010. Reforming Financial Regulation to Address the Too-Big-to-Fail Problem. Brooklyn Journal of International Law. 35(3): 707–783.Google Scholar
  83. Yellen, Janet L. 2012. Revolution and Evolution in Central Bank Communications. Remarks by Janet L. Yellen, Vice Chair Board of Governors of the Federal Reserve System at Haas School of Business, University of California, Berkeley, California. November 13.Google Scholar

Copyright information

© The Author(s) 2019

Authors and Affiliations

  1. 1.NG ConsultingParisFrance
  2. 2.RJM ConsultingNew York CityUSA

Personalised recommendations