'Moral Hazard' Argument Not So Cut and Dried

NEW YORK (TheStreet) -- "Moral hazard" is a term frequently thrown around as a reason to break up financial institutions considered "too big to fail," but the academics and policymakers making that argument may be oversimplifying the problem.

Moral hazard occurs when a person or company is incentivized -- for instance, by having access to inexpensive insurance against losses, or having confidence in being bailed out if they are subsumed by losses -- to take excessive risks. In testimony before a House committee examining his proposal to address the too-big-to-fail issue on Thursday, Treasury Secretary Timothy Geithner went beyond previous statements to say that big banks may be forced to shrink, because the bailout actions of the past year had created moral hazard. But the moral hazard issues in the banking industry aren't quite so cut and dried.

Few banks are eager to take federal money to shore up their balance sheets. In fact, the healthy ones that would have more flexibility to use those funds to take excessive risk -- rather than cover losses from bad loans -- eagerly repaid Troubled Asset Relief Program dollars over the summer. The large banks in the spotlight for still having TARP are even more eager to pay it back, due to what they see as micromanagement from regulators and excessive restrictions on pay and lending operations.

In this situation, banks actually want to get rid of bailout dollars to make profits.

Furthermore, making banks smaller will not discourage them from taking risks. If the housing crisis had occurred while a too-big-to-fail mandate had been in place, all the different businesses of a JPMorgan Chase (JPM Quote), Bank of America (BAC Quote), Citigroup (C Quote), Wells Fargo (WFC Quote), Goldman Sachs (GS Quote) or Morgan Stanley (MS Quote) would have been in trouble, because everyone from the borrower to the lender to the trader to the mortgage-security holder has suffered.