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Corporate Governance Part 2 - Corporate governance is the collection of…
Corporate Governance Part 2 - Corporate governance is the collection of mechanisms, processes and relations by which corporations are controlled and operated
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Moral Hazard
Financial bailouts of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.
Knowing that the Government was there to help them, banks and other investors were free to make irresponsible commitments.
Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent.
The phrase moral hazard refers to the risk that the presence of a contract will effect on the behaviour of one or more parties. The classic example is often deemed to originate from the insurance industry, where coverage against a loss might increase the risk-taking behaviour of the insured. The fact that the loss is protected in some tangible way means that the risk appetite of the insured is skewed. When applied to the behaviour of managers and executives in a financial trading firm, one can infer how the issue of moral hazard may increase the likelihood of irrational behaviour towards risk taking.