Moral Hazard

In economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs and/or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

For example, with respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain payments and that, for this reason, the loans were not, in the long run, going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.

Another, more complex, example would be the euro debt crisis, in which the troika of relief funds (aka the ECB, the IMF, and the EC) for heavily indebted nations like Greece are waiting as long as possible to act. The risks of a money run, and the consequential market crash in Europe is by far not as detrimental to these institutions as to the indebted nations themselves.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk 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 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.