Lehman failure and moral hazard

It is widely acknowledged that bailouts further moral hazard. They are supposed to make lenders and borrowers even more reckless in the firm belief that they are likely to be bailed out in case they run into problems. This line of reasoning partially explains why the investment banking major Lehman Brothers was allowed to fail.

But there are influential voices who now feel that instead of reducing moral hazard, the decision to not bailout Lehman may have, ironically enough, increased moral hazard. The decision to permit Lehman to go under and its role in triggering off the cascade of events that led to the collapse in confidence across global financial markets, sends strong signal across the spectrum. Government agencies would now be more inclined to feel that such large broker-dealers are too big to be allowed to fail, and therefore should intervene to bail them out. Similarly, the executives of large financial institutions facing such difficult times, are likely to be reassured (and therefore made even more reckless!) by the comfort of bailout insurance!

Therefore, as James Surowiecki says, the Lehman bankruptcy now makes it appear more important, to both policymakers and market participants, to save the troubled auto makers like General Motors!