Moral Hazard: Definition and Examples

The Temptation to Take Risks When You Won't Shoulder the Consequences

Temptation
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Moral hazard is when one party can take risks knowing the other party will bear the consequences. It describes the risk present when two parties don't have the same information about actions that take place after an agreement is in place. The situation creates a temptation to ignore the moral implications of a decision: doing what benefits you most instead of doing what is right.

Example of Moral Hazard in Insurance

Moral hazard is a term that originated in the insurance industry and spread to the financial sphere. To illustrate the concept, imagine you rent a car and opt for the maximum insurance coverage possible. Damaging the vehicle does not have significant negative consequences for you, because the insurance company pays for repairs—or a replacement car—if something happens.

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 for insurance than it would cost to repair a car because, in most cases, the insurance company won't have to pay for any repairs. But there are times when you might have an unfair information advantage over your insurance company. That's where moral hazard comes in.

You 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. The low cost of insurance means you have no incentive to protect the car you rented, but the insurance company doesn't know you're driving it under such conditions.

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. In this example, the insurance company bears the risk: the cost of repairing or even replacing the car.

The more insulated you are from risk, the more temptation you face.

Examples of Moral Hazard in Lending

Moral hazard became a significant factor during (and after) the financial crisis that began in 2007. The concept can apply to both lenders and borrowers.

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 the brokers 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 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 the 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 to 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.

The moral hazard was the lenders and investment banks taking risks that had consequences not for themselves, but for taxpayers and others.

Borrowers

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

During the financial crisis, 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.

The moral hazard in these cases was that borrowers, increasingly underwater on their home loans, would be tempted to walk away from their mortgage rather than repay it. Such an action would put risk back onto the lender. The hazard is that the borrower no longer had an incentive to do the right thing—to pay back the mortgage as agreed.