Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently at the peril of the other party. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.
If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlord require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.
Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions
Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.
In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me.
In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's do?
If it can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.
The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from new loans that it can get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for more profitable but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off.
Neither the the bank nor the depositors are behaving they way they would in the absence of deposit insurance. That is the essence of moral hazard.
1 comment:
I believe that this is true because many of the banks need to focus more on the moral side. I believe that the banking one is true you can see that many companies as well as people go for the riskier loans so that they are able to make up for their losses. The used car one is also kind of funny because my dad rents cars and is more delicute with it then his old used jeep that he used to drive.
James B
Money and Banking
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