4.8 The bonuses of midlevel bank loan managers are often based on the profits but not the losses of the loans they approve. Suppose that an executive can make two types of loans: risky loans, which yield a large profit if they are successful and incur a large loss if they fail, and safe loans, which return a small profit if they are successful and incur a small loss if they fail. If a bank incurs a sufficiently large loss, the government takes it over and usually merges it with another, stronger bank. Some of the midlevel executives will lose their jobs, but most will retain them.

a. After a loan manager is hired, what moral hazard problem do the bank’s top executives face?

b. If you were a bank executive, what actions could you take to mitigate the moral hazard?

c. If you were a government regulator, what regulations could you suggest to mitigate the moral hazard?