Moral hazard

Moral hazard

Discussion
Ask a question about 'Moral hazard'
Start a new discussion about 'Moral hazard'
Answer questions from other users
Full Discussion Forum
 
Encyclopedia
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

 behaves differently from how it would if it were fully exposed to the risk.

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. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.

Economists explain moral hazard as a special case of information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

, 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.

Theory


According to contract theory
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...

, moral hazard results from a situation in which a hidden action occurs. Quoting Bengt Holmström,
The name 'moral hazard' comes originally from the insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

 industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed, or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as they would like to be protected.

Economists argue that this inefficiency
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

 results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed, or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. But since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.

Economists distinguish moral hazard from adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...

, another problem that arises in the insurance industry, which is caused by hidden information rather than hidden actions.

The same underlying problem of unobservable actions also affects other contexts, besides the insurance industry. It also arises in banking and finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

: if a financial institution knows it is protected by a lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...

, it may make riskier investments than it would in the absence of this protection.

Moral hazard problems also occur in employment relationships. When a firm is unable perfectly to observe the actions taken by its employees, it may be impossible to achieve efficient behavior in the workplace—for example, workers' effort may be inefficiently low. This is called the principal–agent problem, which is one possible explanation for the existence of involuntary unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

. Similar problems may also occur at the managerial level, because owners of firms (shareholders) may be unable to observe the actions of a firm's managers, opening the door to careless or self-serving decision-making.

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 a before the event 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 (after the event) 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 forgo 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
Kenneth Arrow
Kenneth Joseph Arrow is an American economist and joint winner of the Nobel Memorial Prize in Economics with John Hicks in 1972. To date, he is the youngest person to have received this award, at 51....

, Tom Baker, and John Nyman.

John Nyman suggests that two types of moral hazard exist: efficient and inefficient moral hazard. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medial care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.

Insurance analysts sometimes distinguish moral hazard from a related concept they call morale hazard
Morale hazard
In insurance analysis, morale hazard is an increase in the hazards presented by a risk arising from the insured's indifference to loss because of the existence of insurance. Insurance analysts distinguish this from moral hazard...

.

In finance



Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

 described moral hazard as: "...any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly." 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 potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So-called "too big to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...

" lending institutions can make risky loans that will pay handsomely if the investment turns out well, while being bailed out by the taxpayer if the investment turns out badly.

Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions. According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last twenty-years, all were resolved by bail outs at taxpayer expense.

Economist Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...

 of Moody's Analytics
Moody's Analytics
Moody’s Analytics provides capital markets and risk management professionals with credit analysis, economic research, financial risk management software, and advisory services...

 described moral hazard as a root cause of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

. He wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."

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 with their cards, because without such limits borrowers may spend borrowed funds recklessly, leading to default.

Securitization of mortgages in America, beginning in 1983 at Salomon Brothers, was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the present mortgage securitization system in the United States, many different debts of many different borrowers are piled together into a great big pool of debt, and then shares in the pool are sold to lots of creditors – which means that there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language that the papers that he/she signed were written in, or even that the paperwork exists and is in good order. It has been suggested that this may have caused 2007–2008 subprime mortgage financial crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

.

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
Musical chairs
Musical chairs is a game played by a group of people , often in an informal setting purely for entertainment such as a birthday party...

) 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.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior, since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout will prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and burdens of loss became apparent to Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...

 (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank
Citibank
Citibank, a major international bank, is the consumer banking arm of financial services giant Citigroup. Citibank was founded in 1812 as the City Bank of New York, later First National City Bank of New York...

 and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

.

In management


Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:
  • When a manager has a secure
    Job security
    Job security is the probability that an individual will keep his or her job; a job with a high level of job security is such that a person with the job would have a small chance of becoming unemployed.-Factors affecting job security:...

     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
    Nepotism
    Nepotism is favoritism granted to relatives regardless of merit. The word nepotism is from the Latin word nepos, nepotis , from which modern Romanian nepot and Italian nipote, "nephew" or "grandchild" are also descended....

     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 a manager may readily lay blame on an innocent subordinate.
  • When there is no clear means of determining who is accountable for a given project.


The software development
Software development
Software development is the development of a software product...

 industry has specifically identified this kind of risky behavior as a management anti-pattern
Anti-pattern
In software engineering, an anti-pattern is a pattern that may be commonly used but is ineffective and/or counterproductive in practice.The term was coined in 1995 by Andrew Koenig,...

, but it can occur in any field.
  • When senior management has its own remuneration as its primary motivation for decision making (ex. hitting short term quarterly earnings targets or creating high medium term earnings, without due regard for the medium term effects on, or risks for the business, so that large bonuses can be justified in the current periods). The shielding occurs because any eventual hit to earnings can most likely be explained away, and in the worst case, if an executive is terminated, usually the executive keeps the high salary and bonuses from years past.
  • When a numbered company
    Numbered company
    A numbered company is a corporation, most commonly found in Canada, given a generic name based on its sequentially-assigned corporation number. For instance, an entity incorporated under the Canada Business Corporations Act and assigned the corporation number 1234567 would be entitled to register...

     is used for construction projects as a subsidiary of a larger enterprise. For example: a numbered company is incorporated to construct a condominium in Vancouver. It is built to meet the minimum building code requirements, but is not designed for Vancouver's typical weather patterns (mild temperatures, lots of moisture). A few years later, the exterior cladding of the building is disintegrating with mold and rot. The numbered company that built it has no assets, so the condominium owners must suffer a large expense to rebuild it. In this scenario, the senior officers of the numbered company and its shareholders used the protection of a numbered limited liability company in order to take higher risks in the design and construction. Unless the law and the regulators have some effective means to hold those responsible to account, the Moral Hazard would be expected to continue to future building projects.


In extreme cases, moral hazard can lead to or permit control fraud
Control fraud
Control fraud occurs when a trusted person in a high position of responsibility in a company, corporation or state uses their powers to subvert the organization and to engage in extensive fraud for personal gain....

 to occur, where actual illegal activities take place.

History of the term


According to research by Dembe and Boden, the term dates back to the 17th century, and was widely used by English insurance companies by the late 19th century. 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 18th century 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

  • Conflict of interest
    Conflict of interest
    A conflict of interest occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other....

  • Externality
    Externality
    In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...

  • Feedback
    Feedback
    Feedback describes the situation when output from an event or phenomenon in the past will influence an occurrence or occurrences of the same Feedback describes the situation when output from (or information about the result of) an event or phenomenon in the past will influence an occurrence or...

  • Free rider problem
    Free rider problem
    In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...

  • Game theory
    Game theory
    Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

  • Information economics
    Information economics
    Information economics or the economics of informationis a branch of microeconomic theory that studies how information affects an economy and economic decisions. Information has special characteristics. It is easy to create but hard to trust. It is easy to spread but hard to control. It...

  • Offset hypothesis
  • Perverse incentive
    Perverse incentive
    A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...

  • Samaritan's dilemma
    Samaritan's dilemma
    Samaritan's Dilemma refers to a dilemma in the act of charity. It hinges on the idea that when presented with charity, in some location such as a soup kitchen, a person will act in one of two ways: using the charity to improve their situation, or coming to rely on charity as a means of survival.The...

  • Systemic risk
    Systemic risk
    In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...

  • Unintended consequence
    Unintended consequence
    In the social sciences, unintended consequences are outcomes that are not the outcomes intended by a purposeful action. The concept has long existed but was named and popularised in the 20th century by American sociologist Robert K. Merton...


External links

  • Saintjoe.edu, Discussion of moral hazard and insurance by Robert Schenk
  • Gladwell.com, The Moral Hazard Myth (in Health Care)
  • TheBigMoney.com, What is Moral Hazard
  • Press.illinois.edu, What's so Moral about the Moral Hazard?
  • Marketwatch.com, Uncle Sam
    Uncle Sam
    Uncle Sam is a common national personification of the American government originally used during the War of 1812. He is depicted as a stern elderly man with white hair and a goatee beard...

    as sugar daddy; Marketwatch Commentary: The moral hazard problem must not be ignored
  • PBS.org, Inside the Meltdown, PBS's Frontline episode uses the idea as a central theme
  • Mises.org, A comparison of the conventional views of moral hazard, with that by Austrian economists