Module: | MODULE B: RISK MANAGEMENT
Q302: Scenario: A massively interconnected global bank engages in highly speculative derivative trading, knowing that its collapse would devastate the national economy, forcing the government to bail it out. Based on the principles of risk regulation, consider the following statements regarding the regulatory response to this "Too Big To Fail" paradox:
1. Regulators encourage such banks to increase their risk appetite to stimulate rapid macroeconomic growth.
2. The status creates a severe moral hazard, as the bank privatizes its profits while socializing its potential losses.
3. To combat this, modern frameworks classify such entities as Systemically Important Financial Institutions, subjecting them to higher capital surcharges.
Which of the statements given above is/are correct?
2. The status creates a severe moral hazard, as the bank privatizes its profits while socializing its potential losses.
3. To combat this, modern frameworks classify such entities as Systemically Important Financial Institutions, subjecting them to higher capital surcharges.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: Regulators actively try to de-risk highly interconnected entities, not encourage them to take more speculative risks for economic growth, as their failure would be catastrophic.
Statement 2 is correct: The core problem of the Too Big To Fail (TBTF) paradox is moral hazard.
Because the bank knows it is indispensable to the economy, it takes outsized risks, keeping the profits during good times (privatizing profits) but relying on taxpayer-funded government bailouts during crises (socializing losses). Statement 3 is correct: To address this market distortion, the Financial Stability Board (FSB) and Basel framework label these mega-banks as Systemically Important Financial Institutions (SIFIs or D-SIBs locally). Once classified, they are subjected to rigorous scrutiny and mandatory higher capital surcharges to absorb potential losses independently.
Statement 2 is correct: The core problem of the Too Big To Fail (TBTF) paradox is moral hazard.
Because the bank knows it is indispensable to the economy, it takes outsized risks, keeping the profits during good times (privatizing profits) but relying on taxpayer-funded government bailouts during crises (socializing losses). Statement 3 is correct: To address this market distortion, the Financial Stability Board (FSB) and Basel framework label these mega-banks as Systemically Important Financial Institutions (SIFIs or D-SIBs locally). Once classified, they are subjected to rigorous scrutiny and mandatory higher capital surcharges to absorb potential losses independently.