Moral Hazard and the Justification of Bailouts

This semester I'm talking the Business Law course and we had a guest speaker who talked about the current crisis.

 The discussion eventually turned to the Lehman failure, the bailout of AIG, GM and other companies. One of the arguments that came up in favor of the bailouts was that there was no moral hazard, because shareholders would lose most of their equity in bailed out company.

The concept of moral hazard is best understood with this example: imagine an insurance against laptop theft. By taking that insurance you would be guaranteed that you laptop would be replaced if it gets stolen. This is good, because it covers you from an undesirable event. But it also encourages some people to be less careful with their laptops thus increasing the overall risk. The same happens with companies, when the government saves them from bankruptcy, it is sending a message to the all other players in the market that they can be less careful because the government is providing an insurance against failure. 

This was the main arguments of those who supported the Lehman failure. However those who supported bailing out Lehman argued that stockholders lost most of their equity and thus were already punished, so there is no Moral Hazard.

 But Moral Hazard is hardly limited to shareholders. Employees, customers, suppliers and regulators are all part of the game. In a normal situation if a company goes bankrupt, all players including shareholders, customers, employee, suppliers and regulators suffer the pain and as a result learn and avoid creating a similar situation in the future.

 However when a company is not allowed to fail, such as AIG, employees, clients and suppliers get away with their mistakes. 

 The message that is sent to customers is: "don't worry; if you buy from a company that is too big to fail, you are taking no risk because the government will back it up".

 The message that is sent to suppliers is: "don't worry; if you sell to company and give credit and loans to a company that is too big to fail, you are taking no risk because the government will be there in case of problems"

 And similarly to employees, regulators and other stakeholders.

 As you can see, bailing out failing companies even when punishing shareholders can encourage riskier behaviors in the future.