Moral Hazard: Definition and Examples

Take risks without taking responsibility

Temptation
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Moral hazard is the concept of somebody taking advantage of a situation by taking risks that others will pay for. When that happens, the consequences of risk-taking don’t fall on the party taking action, but they still receive all of the benefits. The situation creates a temptation to ignore the moral implications of a decision: Instead of doing what is right, you can do what benefits you most.

The Concept of Moral Hazard

Moral hazard originated in the insurance industry. Insurance is a way to transfer risk to somebody else by paying a premium, but insurance works best when moral hazard is not at work.

Example: If you rent a car and opt for the maximum insurance coverage possible, damaging the vehicle does not have significant negative consequences. The insurance company will pay for repairs—or a replacement car—if something happens. In exchange for that coverage, you pay a price that seems fair, and everybody is satisfied.

Information advantage: Insurance works best when neither you nor your insurance company expects any damage to occur. The insurance company uses statistics to estimate how likely the vehicle is to suffer damage, and they price their services accordingly. You pay much less than it costs to repair a car because, in most cases, the insurance company doesn’t have to pay for any repairs. But there are times when you might have an unfair information advantage over your insurance company.

Moral hazard example: How might moral hazard enter the picture? You might plan to drive into the mountains on rough, narrow roads. So, you get the most generous insurance coverage possible, and you don’t worry about bouncing over rocks or scratching the paint in thick brush along the side of the road. You might even have a perfectly good car available at home, but there’s no way you’re going to drive your vehicle up that road—so you rent a car and buy insurance.

Again, moral hazard happens when you have an incentive to take risks that somebody else will pay for: You get to do whatever brings you the greatest potential benefit, and you don’t suffer the consequences. The more insulated you are from risk, the more temptation you face.

Moral Hazard and Loans

Moral hazard became a significant factor during (and after) the financial crisis that began in 2007. There are two ways to think about moral hazard and loans.

Lenders: Lenders were eager to approve loans before the mortgage crisis. Some mortgage brokers encouraged “subprime” borrowers to lie on loan applications, or they altered documents to make it appear that borrowers were able to afford loans that they really couldn’t afford. For example, sometimes they reported inaccurate income numbers, or they did not require documentation that would demonstrate a borrower’s ability to repay the loan.

Why would lenders hand out money when they don’t really know if the borrower can afford the payments—especially if they have to commit fraud to get the loans approved? In many cases, the lenders were only originating (or selling) the loans. After approving and funding loans, lenders would sell the loans to investors, who eventually suffered losses. In other words, the lender took little or no risk. But lenders had an incentive to keep making new loans because that's how originators generate revenue.

When things turned sour, lawmakers and the public got scared. They worried that if major banks collapsed (some of them were loan originators, while others held risky investments), they would bring down the U.S. economy—not to mention the global economy. Because these banks were considered “too big to fail,” the U.S. government provided funding to help some of them weather the economic storm. If those banks suffered significant losses, the government promised to protect deposits (in some cases through the FDIC).

Of course, taxpayers fund the U.S. government, so the taxpayers were ultimately bailing out the banks.

To restate the previous sentence: Lenders and investment banks took risks that had consequences for taxpayers and others (or potential impacts, for those who didn’t actually lose money or suffer).

Borrowers: Moral hazard also exists with borrowers. As millions of homeowners struggled to pay their mortgages and loan defaults skyrocketed, government programs offered relief. People could avoid foreclosure thanks to money and guarantees from the U.S. government.

Some critics worried that borrowers would have an incentive to walk away from their mortgages: They were underwater on home loans, and they might be tempted to get government aid that they didn’t need. In some cases, their credit might suffer, but in other cases, borrowers would come out unscathed (although struggling borrowers almost certainly experienced financial hardship and emotional stress).

Other Situations

Moral hazard can occur in almost any agreement, whether it’s an informal understanding or formal contract. If one party has the opportunity to benefit from taking “risks”—while risking almost nothing—moral hazard is at play.