What Is Moral Hazard?
Moral hazard describes a situation in economics and behavioral finance where one party increases its exposure to risk because another party will bear the costs of that risk. It arises when there is information asymmetry between two parties in a transaction, meaning one party has more or better information than the other. This imbalance can lead to a change in behavior by the protected party, often to the detriment of the party bearing the potential costs. For instance, in insurance, if policyholders are fully protected against losses, they might take fewer precautions to prevent those losses, shifting the burden onto the insurer.
History and Origin
The concept of moral hazard has roots dating back to the 17th century, gaining significant traction within English insurance companies by the late 19th century. Early usage of the term often carried pejorative connotations, implying fraud or unethical behavior on the part of the insured party. However, its interpretation evolved, particularly with economists in the 1960s, notably Kenneth Arrow, who approached moral hazard as a technical term to describe inefficiencies that arise when risks are displaced or not fully evaluable, rather than as a judgment of morality.24 Academics Rowell and Connelly have detailed the genesis of the term, tracing its shifts in economic and philosophical thought.23
Key Takeaways
- Moral hazard occurs when one party is insulated from risk and, as a result, acts more carelessly or takes on greater risks.
- It is fundamentally linked to information asymmetry, where the risk-taking party has more information about their actions than the cost-bearing party.
- The concept is prevalent across various sectors, including finance, healthcare, and insurance.
- Government bailouts of large financial institutions are often cited as examples of creating moral hazard.
- Mitigating moral hazard often involves strategies like aligning incentives, monitoring, and establishing clear consequences for risk-taking.
Interpreting the Moral Hazard
Interpreting moral hazard involves understanding how protective mechanisms can inadvertently influence behavior. When individuals or entities are shielded from the full consequences of their risk-taking, they may have less incentive to behave cautiously. This often manifests as a principal-agent problem, where the agent (the party taking action) may prioritize their own interests over those of the principal (the party bearing the risk), especially when the principal cannot fully observe or control the agent's actions. Recognizing the potential for moral hazard is crucial for designing effective contracts, policies, and regulations that promote responsible behavior.
Hypothetical Example
Consider a hypothetical company, "SecureBank," which offers loans. Traditionally, SecureBank carefully vets its borrowers and their projects, knowing that any loan defaults directly impact its profitability. Now, imagine a new government program is introduced that guarantees a significant portion of all loans made by banks, up to 90% of the loan value, in the event of a borrower default.
With this new guarantee, SecureBank's incentives shift. Knowing that 90% of a potential loss is covered by the government, SecureBank might become less stringent in its loan approval process. It might begin approving loans to borrowers with weaker credit histories or for riskier projects that it would have previously rejected. The bank's internal risk management protocols might loosen because the downside risk has been substantially mitigated. If a large number of these riskier loans default, the government (and ultimately, taxpayers) would bear the majority of the losses, while SecureBank would have profited from originating the loans without absorbing the full associated risk. This change in behavior due to the reduced personal cost of failure exemplifies moral hazard.
Practical Applications
Moral hazard is a pervasive concept with significant practical applications across various financial and economic domains. In the context of financial regulation, particularly after the 2008 financial crisis, the issue of "too big to fail" financial institutions highlighted how the implicit or explicit promise of government bailouts can encourage excessive risk-taking by large banks, as they anticipate being rescued to prevent broader systemic risk.19, 20, 21, 22
Similarly, the International Monetary Fund (IMF) faces discussions about whether its financial assistance to countries experiencing economic crises creates moral hazard by reducing the incentive for those nations to implement sound economic policies. Critics argue that the knowledge of potential IMF intervention might encourage governments and private creditors to engage in riskier behavior, as they expect the IMF to provide liquidity and prevent default, thereby weakening pressures for sustainable fiscal policies and robust financial supervision.18
In health economics, moral hazard is evident when individuals with comprehensive health insurance may utilize medical services more frequently or opt for more expensive treatments than they would if they bore the full cost. This behavioral change can lead to overutilization of healthcare resources and contribute to rising healthcare costs.15, 16, 17
Limitations and Criticisms
While moral hazard is a widely accepted concept in economic theory, its application and interpretation are not without limitations and criticisms. Some argue that the term itself can carry a pejorative connotation, implying a lack of ethics or integrity on the part of the insured or protected party, whereas economists often view it as a rational response to altered incentives and reduced cost.13, 14
A key challenge in addressing moral hazard, particularly in areas like deposit insurance, is finding a balance between providing necessary protection and preventing excessive risk-taking. For example, federal deposit insurance protects depositors, but it can also reduce the incentive for depositors to monitor their bank's financial health, thereby diminishing market discipline on banks.10, 11, 12 Research from the Federal Deposit Insurance Corporation (FDIC) explores how risk-based premiums can be used to mitigate moral hazard by providing stronger incentives for banks to curb their risk-taking behavior.9 However, completely eliminating moral hazard is often impossible, as some level of protection or risk-sharing is necessary for the functioning of markets and social welfare.
Moral Hazard vs. Adverse Selection
Moral hazard and adverse selection are distinct but related concepts in economics, both stemming from information asymmetry. Moral hazard refers to a change in behavior after a transaction has occurred, where one party, shielded from risk, acts differently than they would have if fully exposed to the consequences. For example, a driver with full collision insurance might drive less cautiously.
In contrast, adverse selection refers to a situation before a transaction, where one party has private information that leads them to participate in a transaction that is disadvantageous to the other party. For instance, in health insurance, individuals who know they are sicker (and thus more likely to need extensive medical care) are more likely to purchase comprehensive insurance plans, while healthier individuals might opt for less coverage or none at all. This difference in pre-existing information can skew the pool of insured individuals, making it more costly for insurers. Both concepts deal with information imbalances but at different stages of a contractual relationship.8
FAQs
What causes moral hazard?
Moral hazard is primarily caused by information asymmetry, where one party in a transaction lacks full information about the actions or intentions of the other party. This allows the party with more information to take greater risk-taking because they are insulated from the full consequences of their actions.
Is moral hazard always negative?
While often discussed in a negative light due to its potential for inefficiency and increased costs, moral hazard is not inherently "immoral."6, 7 It describes a behavioral response to altered incentives and risk distribution. In some cases, accepting a degree of moral hazard might be a necessary trade-off for broader benefits, such as ensuring financial stability through deposit insurance or providing social safety nets.
How is moral hazard prevented or mitigated?
Mitigating moral hazard involves various strategies, including closer monitoring of behavior, designing contracts that align incentives between parties (e.g., deductibles in insurance), implementing robust financial regulation, and fostering greater transparency. For example, in the banking sector, increased capital requirements aim to make banks bear more of the costs of their risk-taking, reducing their reliance on potential bailouts.
What role did moral hazard play in the 2008 financial crisis?
Moral hazard is considered a significant factor in the 2008 financial crisis.3, 4, 5 The belief that large financial institutions were "too big to fail" led to excessive risk-taking in the housing and derivatives markets, as these institutions anticipated government intervention to prevent their collapse.1, 2 When the crisis hit, government bailouts were implemented to prevent systemic risk, which some argue reinforced the perception of implicit guarantees, potentially exacerbating future moral hazard.