Trust, Risk, And Moral Hazard In Financial Markets

This book identifies structural features of financial markets that make them vulnerable to the sorts of instability that generated the crisis of 2008-2009. The author explains why trust is an essential feature of these markets, and investigates both why trust works so well to sustain markets in normal times and why it breaks down so quickly in times of crisis. Trust in human societies is protected by three institutions: culture, law, and self-help. While culture and law are important in financial markets, they do not reliably protect trust when the financial instruments in question are very short term in nature (such as bank deposits). Here, the parties must protect themselves by self-help - a reliable protection in ordinary times and a very unreliable one in times of crisis. The author then explores other central features of financial markets, including concepts of moral hazard - the fact that government insurance and bail­outs may enhance the risk that financial institutions will take unwarranted risks - and also intellectual hazard - the tendency of complex organizations to make erroneous judgments about risk. The author provides an insightful analysis of the causes of the recent crisis and of the future prospects of the world's financial system in light of the reforms that countries around the world have undertaken in an attempt to ensure that an event of this type does not happen again.