'Moral Hazard' Inefficient? The Policy Implications Of A New

Andrew Beattie was part of the original editorial team at i-google-map.com & has spent twenty years writing on a diverse range of financial topics including business, investing, personal finance, and trading.

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Ebony Howard is a certified public accountant và credentialed tax expert. She has been in the accounting, audit, và tax profession for more than 13 years.

What Is a Moral Hazard?

A moral hazard is an idea that a các buổi tiệc nhỏ protected from risk in some way will act differently than if they didn"t have that protection. We encounter moral hazard every day—tenured professors who become indifferent lecturers, people with theft insurance becoming less vigilant about where they park, salaried employees who take long breaks, và so on.


Moral hazard is usually applied lớn the insurance industry. Insurance companies worry that by offering payouts to lớn protect against losses from accidents, they may actually encourage risk-taking. This often forces them to pay out more in claims. Insurers fear that a "don"t worry, it"s insured" attitude often leads policyholders with collision insurance lớn drive recklessly or fire-insured homeowners lớn smoke in bed.


A moral hazard is an idea that a tiệc nhỏ protected from risk in some way will act differently than if they didn"t have sầu that protection.In the insurance industry, moral hazard occurs when insured parties take more risks knowing their insurers will protect them against losses.Considered khổng lồ be too big to fail, banks often take additional financial risks knowing they"ll be bailed out by the government.Because purely free-market capitalism doesn"t exist, taxpayers kết thúc up footing the bill for moral hazards committed by large corporations.

Understanding Moral Hazard

The basic premise behind a moral hazard is that an individual or one các buổi tiệc nhỏ involved in a transaction takes on additional—và often unnecessary—risks that usually affect the other buổi tiệc ngọt in the transaction in a negative sầu way.


Consider the idea that a corporation is too bigto lớn fail. If the company"s management believes it will receive a financial bailout to lớn keep it going,they may take more risks to lớn pursue profits. Government safety nets create moral hazards that lead to lớn more risk-taking, & the fallout from markets—meltdowns, crashes,and panics—reinforces the need for more government controls. As such, governments may impose laws to increase the moral hazard in the future.


One alternative sầu khổng lồ creating a moral hazard lượt thích this is to lớn let these corporations fail và allow stronger ones to buy up the wreckage. Although companies would still fail in a truly free-market, the impact would be minimized. There would be no industry-wide meltdowns because most companies would be more cautious, just as most people choose not to smoke in bed whether they are insured or not. Either way, the risk of getting burnedis enough to prompt serious second thoughts.


Since true free-market capitalism doesn"t exist, taxpayers become unwilling market insurers. The problem is insurers profit by selling policies, whereas taxpayers gain little or nothing for footing the bill on the policies and bailouts that create moral hazards.


Real-World Example of Moral Hazard

Moral hazard is all around us. If you want a real-life example, take a look at some of the events that led khổng lồ the 2007-2008 financial crisis and the Great Recession. Interest rates hit rochồng bottom, making credit much cheaper after the dotcom bubble burst. Borrowers flocked to lớn the housing market, including those who couldn"t otherwise afford lớn buy a trang chính. Lenders sold these loans to banks, which packaged them as low-risk investments. These were sold lớn investors who wanted to make a quiông chồng buchồng.

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When the economy began to recover, the Federal Reserve sầu increased interest rates. The housing market crashed, causing property values lớn drop. No longer able to lớn keep up with their mortgage payments, many homeowners ended up walking away from their obligations because their homes were worth less than their debt.


Subprime lenders began filing for bankruptcy, including New Century Financial. As a result of all this, the mortgage-backed securities (MBSs) sold to lớn investors were downgraded and became overvalued. Many firms tried khổng lồ unload these securities but ended up writing them off. Together, they wiped out trillions of dollars in capital from the global banking system.


Everyone plays a key role in preventing và combatting moral hazards like these. The government intervened by lowering interest rates và providing major banks with a bailout lớn prsự kiện them from failing. But sometimes an ounce of prevention is certainly worth a pound of cure. Consumers need lớn be more financially literate, educating themselves of the risks associated with the decisions they make. Lenders, on the other hvà, can—& have—tightened their borrowing requirements to ensure only those who are truly qualified have access lớn credit.


A moral hazard is a risk one các buổi party takes knowing it is protected by another các buổi party. The basic premise is that the protected tiệc nhỏ has the incentive khổng lồ take risks because someone else will pay for the mistakes they make.


Examples of moral hazards include individuals with collision insurance who drive aggressively, students who don't study before an exam but know they'll pass, & employees who take long smoke breaks.


The moral hazard problem in banking is the idea that certain corporations, such as banks & automakers, are too big to lớn fail. These companies usually take risks khổng lồ become more profitable because they know the government will bail them out in the future.


Moral hazard occurs in the insurance industry when the insured tiệc nhỏ takes on additional risks knowing they'll be compensated by their insurance company. Consider an individual with homeowners' & fire insurance who smokes in bed. The homeowner engages in the behavior despite the risks because they know the insurer will pay if they tệp tin a clayên ổn.


The Bottom Line

Moral hazards can be found everywhere. They occur when people và companies take risks knowing they"ll be bailed out by another tiệc ngọt in the kết thúc. Some institutions are set up lớn take advantage of moral hazards, such as the banking system. That"s because the government normally foots the bill, bailing banks out for the mistakes they make. The world saw this during the financial crisis that led to lớn the Great Recession. Although it seems lượt thích the financial industry learned its lesson, only time will tell if the world will experience another, similar cycle.


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