Moral hazard
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 who studied decision-making in the 18th century used "moral" to mean "subjective", which may cloud the true ethical significance in the term.
Economists 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.
The root cause of “moral hazard” is due to the immoral behaviour of economic agents from a social perspective.
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 counterparties of Long-Term Capital Management avoid losses by taking over the firm.
"[7] Fed Chair, Alan 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.
Taxpayers, depositors and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions.
They are similar to the "covered bonds" that are commonly used in Western Europe in that the securitizing agency retains default risk.
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.
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.
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.
A row of regulatory documents has been issued, providing detailed prudential requirements that have many points of contact with the accounting rules and have the indirect effect of curbing the incentives for moral hazard by limiting the discretion left to banks in valuating financial instruments.
[33] Moral hazard has been studied by insurers[34] and academics, such as in the work of Kenneth Arrow,[2][35][36] Tom Baker,[37] and John Nyman.
In those instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.
[39] A second type of behavior that may change is the reaction to the negative consequences of risk once they have occurred and insurance is provided to cover their costs.
These methods work by increasing out-of-pocket expenses for consumers, thereby reducing the incentive for the insured to engage in excessive consumption.
In economic theory, moral hazard is a situation in which the behavior of one party may change to the detriment of another after the transaction has taken place.
In microeconomics, agency theory analyses the relationship between the principal, the party who delegates decision making authority, and the agent, who executes the service.
This theory is a key concept used to explore and resolve issues that have arisen within the relationship of agents and principals, which is known as the principal-agent problem.
[43] Bengt Holmström said this: 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.
[44]Moral hazard can be divided into two types when it involves asymmetric information (or lack of verifiability) of the outcome of a random event.
In the latter case, after the contract has been signed there is a random draw by nature that determines the agent's type (such as his valuation for a good or his costs of effort).
[52][53] Direct tests of moral hazard theory are feasible in laboratory settings, using the tools of experimental economics.
To mitigate the moral hazard, firms may implement various mechanisms such as performance-based incentives, monitoring and screening to align the interests of both parties and reduce the likelihood of risky behaviour.
