International Financial Institutions and Markets Tutorial 1; Author: Sudeep Ajgaonkar, a1607310. Tutorial: 12338 1.

Incentives problems arise in financial contracting where one partys incentives encourage that party to act irresponsibly. Some financial institutions are large enough that their failure could be a threat to the financial system and the economy. Due to the fact that these financial institutions assume that the government could never allow them to fail, they are inclined to take bigger risks. This creates a moral hazard as the assumed safety net provided by the government encourages the financial institutions not to act responsibly with regards to the financial risks they take. There are several ways that this incentive problem could be overcome. One possible solution is to pass legislation that prevents any bailout of a financial institution. Another solution would be to break up a financial institution when it gets so large that its failure could be a threat to the economy. The government could also pass legislation that prevents financial institutions from entering into contracts with high levels of risk. There is also the US governments current plan which would force financial institutions to hold more money in reserve and make it harder for them to borrow too heavily against their assets. Word Count: 195