When the government guarantees the debt obligations of a bank, it can help stabilize the financial market as investors earn peace of mind. However, it can also lead to a moral hazard issue where banks are encouraged to make riskier decisions since they know the government will step in to save them if things go wrong ("too big to fail")

 

One regulatory proposal to help solve this was to require that the banks issue convertible preferred equity that will not be guaranteed by the government. Why might this help avoid the moral hazard dillema? 

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Requiring banks to issue convertible preferred equity that is not guaranteed by the government can h... View the full answer