Moral Hazard

What is Moral Hazard?

Moral hazard refers to the situation that arises when an individual has the chance to take advantage of a financial deal or situation, knowing that all the risks and fallout will land on another party. It means that one party is open to the option – and therefore the temptation – of taking advantage of another party.

The secondary party is the one that suffers all the consequences of any risks taken in a moral hazard situation, leaving the first party free to do as they please, without fear of responsibility. They are able to ignore all moral implications and act in a way that is most beneficial to them.

The Origin of the Issue of Moral Hazard

The phrase “moral hazard” originally comes from the insurance world and is based largely on the fact that each party has different information regarding a situation – specifically, differing information on the actual level of risk.

The issue of misinformation or unequal information is that both parties are not on the same page. Such an issue is dangerous in any business situation, but particularly so in regard to taking out insurance. The party acquiring insurance intends to act in a way that benefits them most, knowing the insurance covers any risks taken. The information is typically not passed on to the insurance company because it would typically result in either higher premium requirements or the inability to obtain the insurance policy.

An Example of a Moral Hazard Situation

One of the best examples of a possible moral hazard situation relates to the circumstances and actions that arose during the aftermath of the financial crisis/housing market crash of 2008. Many of the major banks were sinking like ships with holes, having lost billions in asset value, and the US Federal Government stepped in and bailed them out.

It’s generally believed that as a result of that chain of events, many banks are under the impression that if they ever fall on hard times, the government is going to be there to bail them out. This leads to a moral hazard situation because, rather than taking effective action to prevent overexposure in the future, banks are then more likely to continue making risky loans if doing so offers temporary gains that are beneficial to them.

The moral hazard situation existing between the banks and the US Government is a true example of both one party (the bank) taking advantage of another (the federal government, and ultimately, the taxpayers) and misinformation (the banks are presenting themselves as having amended their policies to avoid future risk, when in practice they may continue to overextend themselves financially).

Final Word

Moral hazard is a tricky situation that makes for unfair and sometimes dangerous financial transactions. Insurance and other financial arenas operate best when moral hazard situations don’t arise.

Both parties entering into a financial relationship should have equal knowledge of the situation and benefits according to each party’s actions. When situations of moral hazard arise, the relationships become, at best, muddled, and, at worst, dangerous.

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Business Ethics
• Mosaic Theory
• Principal-Agent Problem
• Professional
• See all economics resources