Moral Hazard

Definition

Moral hazard refers to the tendency of individuals or entities to take on more risk when they are protected from the consequences of that risk. It arises when an individual or organization does not bear the full cost of their actions and therefore has a reduced incentive to guard against risk.

5 Must Know Facts For Your Next Test

1. Moral hazard can arise in the context of insurance, where policyholders may take on more risk because they know they are protected by their insurance coverage.
2. Deregulation can increase moral hazard by reducing oversight and accountability, leading to riskier behavior by individuals or organizations.
3. Information asymmetry between lenders and borrowers can create moral hazard, as borrowers may take on excessive risk knowing that the lender will bear the consequences.
4. Bank regulation, such as deposit insurance and capital requirements, is designed to mitigate moral hazard in the banking sector.
5. Moral hazard can contribute to financial crises, as individuals or institutions take on excessive risk, knowing they will be bailed out if things go wrong.

Review Questions

• Explain how moral hazard can arise in the context of the Great Deregulation Experiment.
  • During the Great Deregulation Experiment, the reduction in government oversight and regulation led to an increase in moral hazard. Financial institutions and individuals took on more risk, knowing that they would be less accountable for the consequences of their actions. This contributed to the buildup of systemic risk in the financial system, ultimately leading to the financial crisis.
• Describe the relationship between moral hazard, imperfect information, and asymmetric information.
  • Moral hazard is closely linked to the problems of imperfect information and asymmetric information. When one party in a transaction has more or better information than the other, it can lead to moral hazard, as the better-informed party may take on excessive risk, knowing that the consequences will be borne by the less-informed party. This information asymmetry can create a misalignment of incentives, leading to the moral hazard problem.
• Analyze how bank regulation, such as deposit insurance and capital requirements, can be used to mitigate moral hazard in the banking sector.
  • Bank regulation, such as deposit insurance and capital requirements, is designed to address the moral hazard problem in the banking sector. Deposit insurance protects depositors from the consequences of a bank's failure, reducing the incentive for banks to take on excessive risk. Capital requirements, on the other hand, ensure that banks have a sufficient cushion of their own funds to absorb losses, aligning the interests of bank managers and shareholders with the stability of the financial system. By reducing the potential for moral hazard, these regulatory measures aim to promote a more stable and resilient banking sector.

Related terms

Adverse Selection:

Adverse selection occurs when individuals with a higher risk profile are more likely to seek out insurance or other protective measures, leading to a concentration of high-risk individuals in the pool.

Information Asymmetry:

Information asymmetry exists when one party in a transaction has more or better information than the other, which can lead to moral hazard and adverse selection.

Principal-Agent Problem: The principal-agent problem arises when the interests of the principal (e.g., a company's shareholders) and the agent (e.g., the company's managers) are not aligned, leading to moral hazard.