What Is a Moral Hazard?

A moral hazard is an idea that a party protected from risk in some way will act differently than if they didn't have that protection. We encounter moral hazard every day—tenured professors who become indifferent lecturers, people with theft insurance becoming less vigilant about where they park, salaried employees who take long breaks, and so on.

Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking. This often forces them to pay out more in claims. Insurers fear that a "don't worry, it's insured" attitude often leads policyholders with collision insurance to drive recklessly or fire-insured homeowners to smoke in bed.

Key Takeaways

  • A moral hazard is an idea that a party protected from risk in some way will act differently than if they didn't have that protection.
  • In the insurance industry, moral hazard occurs when insured parties take more risks knowing their insurers will protect them against losses.
  • Considered to be too big to fail, banks often take additional financial risks knowing they'll be bailed out by the government.
  • Because purely free-market capitalism doesn't exist, taxpayers end up footing the bill for moral hazards committed by large corporations.

Understanding Moral Hazard

The basic premise behind a moral hazard is that an individual or one party involved in a transaction takes on additional—and often unnecessary—risks that usually affect the other party in the transaction in a negative way.

Consider the idea that a corporation is too big to fail. If the company's management believes it will receive a financial bailout to keep it going, they may take more risks to pursue profits. Government safety nets create moral hazards that lead to more risk-taking, and the fallout from markets—meltdowns, crashes, and panics—reinforces the need for more government controls. As such, governments may impose laws to increase the moral hazard in the future.

One alternative to creating a moral hazard like this is to let these corporations fail and allow stronger ones to buy up the wreckage. Although companies would still fail in a truly free-market, the impact would be minimized. There would be no industry-wide meltdowns because most companies would be more cautious, just as most people choose not to smoke in bed whether they are insured or not. Either way, the risk of getting burned is enough to prompt serious second thoughts.

Since true free-market capitalism doesn't exist, taxpayers become unwilling market insurers. The problem is insurers profit by selling policies, whereas taxpayers gain little or nothing for footing the bill on the policies and bailouts that create moral hazards.

Real-World Example of Moral Hazard

Moral hazard is all around us. If you want a real-life example, take a look at some of the events that led to the 2007-2008 financial crisis and the Great Recession. Interest rates hit rock bottom, making credit much cheaper after the dotcom bubble burst. Borrowers flocked to the housing market, including those who couldn't otherwise afford to buy a home. Lenders sold these loans to banks, which packaged them as low-risk investments. These were sold to investors who wanted to make a quick buck.

When the economy began to recover, the Federal Reserve increased interest rates. The housing market crashed, causing property values to drop. No longer able to keep up with their mortgage payments, many homeowners ended up walking away from their obligations because their homes were worth less than their debt.

Subprime lenders began filing for bankruptcy, including New Century Financial. As a result of all this, the mortgage-backed securities (MBSs) sold to investors were downgraded and became overvalued. Many firms tried to unload these securities but ended up writing them off. Together, they wiped out trillions of dollars in capital from the global banking system.

Everyone plays a key role in preventing and combatting moral hazards like these. The government intervened by lowering interest rates and providing major banks with a bailout to prevent them from failing. But sometimes an ounce of prevention is certainly worth a pound of cure. Consumers need to be more financially literate, educating themselves of the risks associated with the decisions they make. Lenders, on the other hand, can—and have—tightened their borrowing requirements to ensure only those who are truly qualified have access to credit.

Why Is Moral Hazard Important?

A moral hazard is a risk one party takes knowing it is protected by another party. The basic premise is that the protected party has the incentive to take risks because someone else will pay for the mistakes they make.

What Are Examples of Moral Hazards?

Examples of moral hazards include individuals with collision insurance who drive aggressively, students who don't study before an exam but know they'll pass, and employees who take long smoke breaks.

What Is the Moral Hazard Problem in Banking?

The moral hazard problem in banking is the idea that certain corporations, such as banks and automakers, are too big to fail. These companies usually take risks to become more profitable because they know the government will bail them out in the future.

What Causes Moral Hazard in Insurance?

Moral hazard occurs in the insurance industry when the insured party takes on additional risks knowing they'll be compensated by their insurance company. Consider an individual with homeowners' and fire insurance who smokes in bed. The homeowner engages in the behavior despite the risks because they know the insurer will pay if they file a claim.

The Bottom Line

Moral hazards can be found everywhere. They occur when people and companies take risks knowing they'll be bailed out by another party in the end. Some institutions are set up to take advantage of moral hazards, such as the banking system. That's because the government normally foots the bill, bailing banks out for the mistakes they make. The world saw this during the financial crisis that led to the Great Recession. Although it seems like the financial industry learned its lesson, only time will tell if the world will experience another, similar cycle.