Steve Bain

Moral Hazard Explained (with 3 Examples)

Moral hazard is a term in economics that refers to a situation where one party in an activity takes excessive risks because another party bears the cost. This usually represents a type of market failure that is caused by asymmetric information between buyers and sellers, but it can also apply to government failures.

It occurs when an individual or organization is insulated from the negative consequences of their actions, leading to a distortion of incentives and elevated risk-taking behavior.

The moral hazard problem is present in many industries and sectors of the economy, most notably in banking, insurance, and government. Its influence operates through contractual agreements, investment decisions, and regulatory frameworks, distorting the dynamics of risk and reward.

As with other types of market failure there is no simple remedy, but there are actions that can be taken to reduce the harm caused by moral hazard. In the final section of this article, I will describe some of the policy solutions that are typically enacted, but first I will start with some examples of the problem.

Three Examples of Moral Hazard in Economics

There are endless examples of moral hazards in the real world, but the three that stand out are those that apply to the banking & finance sector, the insurance sector, and in government. I will detail these below:

1. Moral Hazard in Banking & Finance

In banking & finance, moral hazard can manifest in the behavior of financial institutions deemed "too big to fail." When entities believe that they will be bailed out in the event of failure, they may engage in riskier activities, knowing that the potential negative consequences will be diverted onto other people.

Systemic threats to the industry, and indeed the entire global financial system, can occur when a big bank faces insolvency. The banking system is highly integrated, with the liabilities/debts of one bank usually being the assets of another. If a bank is allowed to fail, it can spread fear among depositors throughout the system, leading to bank runs as customers rush to withdraw their funds.

Since the systemic threats posed by bank failures are so severe, the banks know that they are highly likely to be bailed out if they run into solvency problems. That being the case, they are able to take reckless risks without the threat of collapse if those risks fail to pay off.

2. Moral Hazard in Insurance

In insurance, moral hazard surfaces when policyholders alter their behavior due to the presence of insurance coverage. For instance, individuals with comprehensive health insurance may be incentivized to engage in riskier activities or neglect preventive measures, knowing that the financial burden of adverse health outcomes will be borne by the insurer.

In extreme cases, the existence of insurance may even encourage fraudulent behavior. Individuals might be tempted to exaggerate the extent of losses or intentionally cause damage, assuming they can make a claim and receive compensation from the insurance company.

3. Moral Hazard in Government

As serious as the moral hazard problems are in insurance, it seems clear that the problems in banking & finance are much worse. However, both pale in comparison to the problems in government.

The root cause of the moral hazard in government is that the full consequences of government actions are often not felt for many years, and sometimes decades. Elected politicians tend to have one main priority above all others, and that is to get re-elected. To achieve that aim there is the ever-present temptation to spend money on one program or another in an attempt to buy votes.

Many government programs are ill-conceived and, when funded with borrowed money, the national debt has a tendency towards unrestrained growth. The cost of this can always be delayed by ‘kicking the can down the road’ so that future generations bear the cost. By that time the politicians who spent irresponsibly will be long gone, never having had to answer for their wasteful projects.

This largely explains the catastrophic mess that the public finances are in at the end of 2023. A catastrophic recession looks inevitable in the coming years.

Moral Hazard vs. Adverse Selection

While moral hazard and adverse selection are distinct phenomena, they share interconnected implications for decision-making processes and market dynamics.

Moral Hazard refers to a situation where one party is incentivized to take risks because it does not have to bear the full consequences of those risks. Adverse selection occurs when one party in a transaction has more information than the other party and uses that information to the detriment of the less-informed party.

For example, in the insurance market, individuals with higher risk levels may be more inclined to purchase insurance, while those with lower risks may avoid it. If the insurer cannot determine which individuals are riskier than others, it will not be able to price discriminate between them. This can lead to a situation where insurers are disproportionately covering higher-risk individuals, leading to higher costs for the insurer.

Moral Hazard Solutions: policy & regulation

Efforts to address moral hazard through policy and regulation necessitate a comprehensive understanding of its manifestations and implications across diverse sectors.

Regulatory frameworks aimed at mitigating its effect within the financial industry often involve stringent capital requirements, stress testing protocols, and resolution mechanisms for failing institutions. These measures seek to instill market discipline, discourage excessive risk-taking, and minimize the likelihood of systemic crises throughout the economy.

In the past there has been talk about breaking up the largest banks in order that, should any one of them fail, the systemic impact on the financial system would be lessened. Unfortunately, the banking lobby group is by far the most powerful in the US, and it seems to have been able to ‘influence’ enough senators to resist any significant move in this direction.

Indeed, even when several small banks did run into problems in March 2023, they were still deemed systemically important with the result that taxpayers’ money flooded in to bail them out. It is unknown to what extent the 2023 bank bailouts were a demonstration of moral hazard, and to what extent it was political corruption. Silicon Valley Bank in particular had many account holders who were big Democrat party donors.

In insurance, policymakers try to design risk-sharing arrangements and incentive structures that reduce any specific firm’s individual risk exposure, and encourage fairer and more efficient claim behaviors by customers.

In automobile insurance, policies such as ‘no-claims-bonuses’ that reduce the cost of insurance premiums when customers do not make claims, add an incentive to avoid frivolous claims. Similarly, ‘voluntary excess’ policies add an element of real cost to accidents that insurance does not cover, thereby giving an incentive to policy-holders to avoid overly risky behavior.

Government behavior remains the fly in the ointment. Effective regulation of government spending is more or less impossible if the government of the day is not committed to it. In many ways the US constitution itself appears to have been consistently violated (at least in spirit) with regard to the way that the Federal Reserve has, in all but name, printed-money to fund government spending.

This type of money-printing is expressly prohibited by the US constitution, but policies like quantitative easing, the bank term funding program, and many funding activities via off balance sheet special purpose vehicles are routinely pursued.

Ultimately, only voters can hold politicians to act, but the information asymmetry between politicians and voters that underlies this moral hazard is vast. It seems unlikely that anything significant will change until the costs of previous rounds of excessive debt-fueled spending are felt, in the form of a tragic economic crisis.

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