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CandleFocus Glossary Editor
Moral hazard is an economic concept that is used to describe the behavior of individuals who do not bear the full cost of their actions. This can be due to the fact that they are insured or have a contract that allows them to take risks without having to suffer consequences for their actions. The concept of moral hazard is most commonly associated with the financial sector, specifically with insurance companies and lending institutions, who often have to cover the costs of their customers’ risky behavior. Moral hazard can also apply in employee-employer relationships, where a lack of consequences may lead employees to act irresponsibly.
The 2008 financial crisis largely stemmed from a moral hazard in the housing market. The availability of large and easy-to-obtain mortgages led to an influx of potential buyers and a corresponding increase in housing prices. Many of the precursor factors to the crisis, such as subprime lending, originated from a lack of incentives to monitor and manage risk appropriately.
When no consequences exist, people and businesses rarely have an incentive to consider the risks of investing, lending or gambling. The resulting moral hazard created by this lack of incentives can be costly. Banks, lenders and other financial institutions that over-invest and under-manage risk can lead to bubbles in the market and can leave taxpayers on the hook for the costs associated with bailing out the financial services sector.
In an ideal world, mitigating moral hazard risk in all types of transactions would be easy. Banks, lenders and insurers would set rules and regulations to ensure that all customers are held to the consequences of their decisions. Employers would be incentivized to monitor and regulate the behavior of their employees. Unfortunately, in the real world it often difficult to completely eliminate moral hazard. The best way to manage moral hazard risk is to ensure that incentives and disincentives are correctly aligned and that rewards and punishments are properly implemented. Moral hazard can be an extremely expensive problem if left unchecked, but with proper management, it can be kept to a minimum.
The 2008 financial crisis largely stemmed from a moral hazard in the housing market. The availability of large and easy-to-obtain mortgages led to an influx of potential buyers and a corresponding increase in housing prices. Many of the precursor factors to the crisis, such as subprime lending, originated from a lack of incentives to monitor and manage risk appropriately.
When no consequences exist, people and businesses rarely have an incentive to consider the risks of investing, lending or gambling. The resulting moral hazard created by this lack of incentives can be costly. Banks, lenders and other financial institutions that over-invest and under-manage risk can lead to bubbles in the market and can leave taxpayers on the hook for the costs associated with bailing out the financial services sector.
In an ideal world, mitigating moral hazard risk in all types of transactions would be easy. Banks, lenders and insurers would set rules and regulations to ensure that all customers are held to the consequences of their decisions. Employers would be incentivized to monitor and regulate the behavior of their employees. Unfortunately, in the real world it often difficult to completely eliminate moral hazard. The best way to manage moral hazard risk is to ensure that incentives and disincentives are correctly aligned and that rewards and punishments are properly implemented. Moral hazard can be an extremely expensive problem if left unchecked, but with proper management, it can be kept to a minimum.