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Moral hazard
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Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.
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Encyclopedia
Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his or her car, because the negative consequences of automobile theft are (partially) borne by the insurance company. Morale hazard is sometimes used to refer to moral hazard which occurs without conscious action.
Moral hazard is related to 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.
A special case of moral hazard is called 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 perfectly 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.
In finance
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. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Essentially, profit is privatized while risk is socialized. Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.
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.
Some believe that mortgage standards became lax because of a moral hazard—in which each link in the mortgage chain collected profits while believing it was passing on risk—and that this substantially contributed to the 2007–2008 subprime mortgage financial crisis.
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.
In insurance
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.
In management
Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur under a number of circumstances:
- When a manager has a sinecure position from which he or she cannot be readily removed.
- When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects.
- When funding and/or managerial status for a project is independent of the project's success.
- When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division.
- When there is no clear means of determining who is accountable for a given project.
The software development industry has specifically identified this kind of risky behavior as a management anti-pattern, but it can occur in any field.
History of the term
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.
See also
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