Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk.
Moral hazard is a special case of information asymmetry, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.
Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well but will be bailed out by the taxpayer if the investment turns out badly.
Politicians and regulators representing the taxpayer and voter may regulate financial institutions to lend money to specific voting blocks, special ethnicities, special interests, favored companies, and unionized businesses with favored unions, rather than regulate financial institutions to lend money in such a fashion as to reduce the risk the taxpayer will have to bail them out, particularly if the bailout is likely to happen after the next election.
Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions. Of the nearly 100 banking crises that have occurred internationally during the last twenty-years, according to the World Bank, all were resolved by bail outs at taxpayer expense.
Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.
Securitization of mortgages in America was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the present mortgage securitization system in America, many different debts of many different borrowers are piled together into a great big pool of debt, and then shares in the pool are sold to lots of creditors – which means that there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write, that he speaks the language that the papers that he signed were written in, that he was sufficiently sober when he signed them to remember signing them, or even that the paperwork exists and is in good order. Various people suggest that this may have caused 2007–2008 subprime mortgage financial crisis.
In the period 1998-2007 regulators kept and published detailed statistics on the ethnicity and location of those receiving loans, but failed to pay similar attention to their credit worthiness, default rates or vulnerability to a housing downturn. The data that the regulators focused on was more relevant to politically mobilizing voting blocks in particular electorates than to keeping the financial system solvent.
Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the 2007–2008 subprime crisis, however, national credit authorities – in the U.S., the Federal Reserve – assumed the ultimate risk on behalf of the citizenry at large.
Others believe that financial bailouts of lending institutions do not encourage risky lending behavior, since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout will prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.
Too big to fail does not protect the shareholders in the too big to fail company against wipeout, but it does protect creditors. AIG shareholders were wiped out, AIG creditors were paid. Too big to fail means that loans to the too big to fail company are risk free, giving it a special privilege to borrow money at easy rates regardless of risk.
Consider the following hypothetical situation: Suppose that dangerous loans, lent to borrowers with few assets and an uncertain income, would pay six percent interest, due to risk, whereas loans made to a too big to fail company would pay two percent interest, since there is little risk. Then the too big to fail company could borrow many times its net worth at low interest, and lend many times its net worth at high interest. Suppose the too big too fail company guarantees, or borrows and lends, one hundred and one times its net worth. Then if all went well, the company would triple its net worth in a year, and if all went badly, its net worth would be wiped out, and the taxpayer would have to pay one hundred times its net worth. Thus the likelihood that a too big to fail company may be wiped out may not provide sufficient threat to deter it from taking excessive risks.
Theoretically "good strong regulation" should restrain too big to fail companies from taking excessive risks, but regulators are frequently former senior executives of the firms that they regulate, for example Henry Paulson, and to the extent that regulators come from the political class rather than the business class, for example William H. Donaldson, they may overlook the risks taken by firms that cooperate enthusiastically in treating finance as a distribution of the spoils of political victory between political voting blocks, as Washington Mutual and Fannie Mae were accused of doing.
In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service—which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.
Two types of behavior can change. One type is the risky behavior itself, resulting in what is called ex ante moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).
A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forego medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.
Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.
Moral hazard has been studied by insurers and academics. See works by Kenneth Arrow, Tom Baker, and John Nyman.
Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:
According to research by Dembe and Boden, the term dates back to the 1600s, and was widely used by English insurance companies by the late 1800s. Early usage of the term carried negative connotations, implying fraud or immoral behavior (usually on the part of an insured party). Dembe and Boden point out, however, that prominent mathematicians studying decision making in the 1700s used "moral" to mean "subjective", which may cloud the true ethical significance in the term.
The concept of moral hazard was the subject of renewed study by economists in the 1960s, and at the time did not imply immoral behavior or fraud; rather, economists use the term to describe inefficiencies that can occur when risks are displaced, rather than on the ethics or morals of the involved parties.