Financial Markets and Institutions Exam 1 Practice

Moral hazard happens when protection changes incentives. If regulators or the government stand ready to bail out or guarantee losses, entities may take on more risk because they expect someone else will bear the costs. In financial regulation, this creates reckless behavior, since the potential downside is socialized rather than borne by the risk-taker. So the statement that moral hazard occurs when entities take excessive risk because they expect protection or bailouts best captures this dynamic. The other options describe different ideas: risk aversion by regulators is the opposite of encouraging risk-taking; funding costs are a normal financing issue; and diversifying too much is about portfolio choices, not protection-driven incentives.