In economics, moral hazard occurs when someone increases their exposure to risk when insured, especially when a person takes more risks because someone else bears the cost of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.
A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.
Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard can occur 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.
For example, with respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain their payments in the long run and that, for this reason, the loans were not going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans.
History of the termEdit
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 then did not imply immoral behavior or fraud. Economists would use this term to describe inefficiencies that can occur when risks are displaced or cannot be fully evaluated, rather than a description of the ethics or morals of the involved parties.
Rowell and Connelly  offer a detailed description of the genesis of the term moral hazard, by identifying salient changes in economic thought, which are identified within the medieval theological and probability literature. Their paper compares and contrasts the predominantly normative conception of moral hazard found within the insurance-industry literature with the largely positive interpretations found within the economic literature. Often what is described as "moral hazard[s]" in the insurance literature is upon closer reading, a description of the closely related concept, adverse selection.
In 1998, William J. McDonough, head of the New York Federal Reserve, helped the counter-parties of Long Term Capital Management avoid loses by taking over the firm. This move was criticized by former Fed Chair, Paul Volcker and others as increasing moral hazard. Tyler Cowen concludes that "creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system." Fed Chair, Allan Greenspan, while conceding the risk of moral hazard, defended the policy to orderly unwind Long Term Capital by saying the world economy is at stake.
Economist Paul Krugman 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 bailouts 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.
Many have argued that certain types of mortgage securitization contribute to moral hazard. Mortgage securitization enables mortgage originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as "agency securitizations", default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality. "Agency Securitizations" refer to securitizations by either Ginnie Mae, a government agency, or by Fannie Mae and Freddie Mac, for-profit government-sponsored enterprises ("GSEs"). They are similar to the "covered bonds" that are commonly used in Western Europe in that the securitizing agency retains default risk. Under both models, investors take on only interest-rate risk, not default risk.
In another type of securitization, known as "private label" securitization, default risk is generally not retained by the securitizing entity. Instead, the securitizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality. "Private label" securitization refers to securitizations structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders.
During the years leading up to the subprime mortgage financial crisis, private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low-quality, high-risk mortgages. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private label securitizations, and performed far better in terms of default rates.
Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "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 started in 1983 at Salomon Brothers and where the risk of each mortgage passed to the next purchaser instead of remaining with the original mortgaging institution. These mortgages and other debt instruments were put into a large pool of debt, and then shares in the pool were sold to many creditors.
Thus, 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 subprime mortgage 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 sub-prime crisis, however, national credit authorities (the Federal Reserve in the US) 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 would prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and the burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.
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The name comes originally from the insurance 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 the clients would like to be protected.
Economists argue that this inefficiency 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. However, 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, another problem that arises in the insurance industry, which is caused by hidden information rather than by hidden actions.
The same underlying problem of non-observable actions also affects other contexts besides the insurance industry. It also arises in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it would in the absence of this protection.
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 further example has been identified in flood risk management where it is proposed that the possession of insurance undermines efforts to encourage people to integrate flood protection and resilience measures in properties exposed to flooding.
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.
In economic theory, moral hazard is a situation where the behavior of one party may change to the detriment of another after the transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. 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 behaves differently from how it would if it were fully exposed to the risk.
It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.
Moral hazard can be divided into two types when it involves asymmetric information (or lack of verifiability) of the outcome of a random event. An ex-ante moral hazard is a change in behavior prior to the outcome of the random event, whereas ex-post involves behavior after the outcome. For example, in the case of a health insurance company insuring an individual during a specific time-period, the final health of the individual can be thought of as the outcome. The individual taking greater risks during the period would be ex-ante moral hazard whereas lying about a fictitious health problem to defraud the insurance company would be ex-post moral hazard. A second example is the case of a bank making a loan to an entrepreneur for a risky business venture. The entrepreneur becoming overly risky would be ex-ante moral hazard, but willful default (wrongly claiming the venture failed when it was profitable) is ex-post moral hazard.
According to Hart and Holmström (1987), moral hazard models can be subdivided in models with hidden action and models with hidden information. In the former case, after the contract has been signed the agent chooses an action (e.g. an effort level) that cannot be observed by the principal. In the latter case, after the contract has been signed there is a random draw by nature that determines the agent's type (e.g., his valuation for a good or his costs of effort). In the literature, two reasons have been discussed why moral hazard may imply that the first-best solution (i.e., the solution that would be attained under complete information) is not achieved. First, the agent may be risk-averse, so there is a trade-off between providing the agent with incentives and insuring the agent. Second, the agent may be risk-neutral but wealth-constrained, so the agent cannot make a payment to the principal and there is a trade-off between providing incentives and minimizing the agent's limited-liability rent. Among the early contributors to the contract-theoretic literature on moral hazard were Oliver Hart and Sanford J. Grossman. In the meantime, the moral hazard model has been extended to the cases of multiple periods and multiple tasks, both with risk-averse and risk-neutral agents. There are also models that combine hidden action and hidden information. Since there is no data on unobservable variables, the contract-theoretic moral hazard model is difficult to test directly, but there have been some successful indirect tests with field data. Direct tests of moral hazard theory are feasible in laboratory settings, using the tools of experimental economics. In such a setup, Hoppe and Schmitz (2018) have corroborated central insights of moral hazard theory.
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Moral hazard problems also occur in employment relationships. When a firm is unable to observe all 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. 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.
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 position and 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 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 industry has specifically identified this kind of risky behavior as a management anti-pattern,[which?] but it can occur in any field.
- When senior management has its own remuneration as its primary motivation for decision making (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 is used for construction projects as a subsidiary of a larger enterprise. An example is a numbered company is incorporated to construct a condominium in Vancouver, British Columbia. It is built to meet the minimum building code requirements, but is not designed for Vancouver's typical weather patterns (mild temperatures, much 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 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, moral hazard would be expected to continue to future building projects. In extreme cases, moral hazard can lead to or permit control fraud to occur, where actual illegal activities take place.
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