Question

What is TARP and how was it funded? What is meant by the term "lender of last resort" and how does it relate to the financial crisis of \(2007-2008 ?\) How do government and Federal Reserve emergency loans relate to the concept of moral hazard?

Short answer

TARP was a $700 billion program to stabilize financial institutions. 'Lender of last resort' refers to central banks providing emergency funds, as the Fed did in the 2007-2008 crisis. Emergency loans raise concerns about moral hazard by potentially encouraging risky behavior.

Step-by-step solution

Understanding TARP

TARP stands for the Troubled Asset Relief Program, a program created in response to the financial crisis of 2007-2008. Its main goal was to purchase distressed assets, particularly mortgage-backed securities, from financial institutions to stabilize the financial system.

Funding of TARP

TARP was funded by a $700 billion authorization from Congress as part of the Emergency Economic Stabilization Act of 2008. This funding was aimed at injecting liquidity into the financial system and restoring market confidence.

Defining 'Lender of Last Resort'

A 'lender of last resort' is typically a central bank, like the Federal Reserve, that provides emergency funds to banks or institutions that are struggling financially and cannot borrow from other sources, to prevent systemic crises.

Lender of Last Resort During the Financial Crisis

During the financial crisis of 2007-2008, the Federal Reserve acted as a lender of last resort by offering loans to financial institutions that were on the verge of collapse, helping to stabilize the financial system.

Understanding Moral Hazard

Moral hazard refers to the risk that a party insulated from risk behaves differently than it would if it were fully exposed to that risk. In finance, it often concerns whether bailouts encourage risky behavior by financial institutions.

Relation of Government Loans to Moral Hazard

Government and Federal Reserve emergency loans during the financial crisis raised concerns about moral hazard, as these bailouts might encourage risky financial behavior by financial institutions, believing they would be rescued in future crises.

Key concepts

Troubled Asset Relief Program (TARP)

The Troubled Asset Relief Program, or TARP, was a major component of the U.S. government's strategy to combat the financial crisis of 2007-2008. It was designed to address the panic that had paralyzed the financial markets by purchasing distressed assets like mortgage-backed securities from troubled financial institutions.
TARP aimed to stabilize the financial system and to prevent further collapses.

• TARP benefited banks by removing problematic assets from their books.
• I t helped restore confidence in the financial industry, which was crucial to rebounding from the crisis.
• By doing this, financial institutions could revive their lending activities, crucial for economic recovery.

In sum, while criticized by some, TARP was a central effort in averting a deeper economic recession.

Lender of Last Resort

The term 'lender of last resort' is often associated with central banks, like the Federal Reserve, that lend money to financial institutions facing critical liquidity shortages. During the financial crisis of 2007-2008, the Federal Reserve played this crucial role.
It provided significant emergency liquidity to those institutions that were unable to secure funding elsewhere.

• This role is vital because it prevents systemic failures that could have severe economic impacts.
• By acting as a lender of last resort, the Federal Reserve helped maintain confidence in the financial system.

Without this safety net, banks might have defaulted, which could have spiraled into a more severe financial meltdown.

Moral Hazard

Moral hazard is a key concept in understanding the implications of financial bailouts. It refers to the risk that entities behave recklessly when they believe they will not have to face the full consequences of their actions. In the context of the 2007-2008 financial crisis, this became a significant concern.

• The question arose: would financial institutions take too many risks, assuming the government would always bail them out?
• This concern suggested that bailouts might inadvertently encourage future risky behavior.

Therefore, while bailouts can prevent immediate harm, they may also create challenges that policymakers need to address to deter irresponsible behavior.

Federal Reserve

The Federal Reserve, or Fed, is central to the U.S. monetary system and played a pivotal role during the financial crisis of 2007-2008. It took numerous unprecedented actions to stabilize the economy.

• The Fed cut interest rates drastically, making borrowing cheaper.
• It expanded its balance sheet by purchasing large quantities of financial assets to increase liquidity in the market.

These actions were crucial in calming the financial panic and setting the stage for economic recovery. The Federal Reserve's involvement was pivotal in ensuring that the monetary and financial systems continued functioning during the crisis.

Government Bailouts

Government bailouts were a critical component of the strategy to combat the financial crisis. These bailouts involved providing vital financial support to key industries and institutions to prevent them from collapsing.

• They helped to avert a more severe economic downturn by stabilizing crucial sectors.
• Bailouts also maintained employment levels in industries that were under severe threat.

However, government bailouts were not without controversy. Some critics argued they rewarded poor management and risky behavior. Despite this, they were integral in preventing a total collapse of the economic system during the crisis.