In the economic literature nowadays, moral hazard is studied in various fields. There are two major categories of researches on moral hazard. One is originated from the early literature about insurance market; the other is about economic decision-making, such as finance, banking, accounting and management. In the recent financial crisis, moral hazard is more frequently discussed and blamed as one of the causes of the banking problem.
What is Moral Hazard?
Moral hazard is defined in various ways in different aspects. The earliest explanation is from the perspective of insurance sector. Marshall provided the definition as ‘any misallocation of resources which results when risks are insured with normal insurance contracts and only with such contracts’. Briefly, moral hazard as the risky behavior an insured individual may act because of the insurance cover. There are two kinds of moral hazard in insurance field. One of them is ex ante moral hazard, which is the risky behavior itself. In this situation, the insured will act risky, which results in more payment by the insurer for the negative consequence. The other one is ex post moral hazard. This is the type of behavior that people change their reaction of risk when insurance is provided or enlarged to cover their cost.
Moral hazard can be also explained in terms of agent-principle problem. In this case, moral hazard is the potential behavior that one party who is in the behalf of another party puts his own interest first. This definition is often used in management area. It is considered as the consequence of asymmetric information.
In some markets, either the buyers or the sellers- usually the sellers- are better informed about the value of the item being traded than the person on the other side of the market. Information about the value of the item being traded that is possessed by only buyers or sellers is called private information. And a market in which the buyers or sellers have private information has asymmetric information. Asymmetric information causes two problems: adverse selection and moral hazard. Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less-informed party.
Examples of Moral Hazard
There are many cases about the moral hazard problem in insurance market. A notable example is about the auto insurance in New Jersey. In the 1980s, New Jersey was considered to have the worst problem on auto insurance. It had no upper limit on the medical costs that could be claimed from any accident and the state even provided auto insurance, Joint Underwriting Authority (JUA), to drivers who are too risky to get insurance from private companies at a similar rate for the less risky drivers. The state suffered a big loss by its insurance policy. The traffic accident rate and car theft rate were much higher than most of other states. Drivers took more risky behavior when they are insured against medical treatments and car theft. The JUA had accumulated a $3 billion deficit at the end of the 1980s and extra taxed were needed to cover the loss which brought big problem to the government.
In finance and banking industry, moral hazard also can be found in various cases. ‘Too big to fail’ banks speculative investment banking activities are guaranteed by the government, because their failure will influent the whole economy. The belief that they will always be rescued from collapse causes these big banks to take greater risks in their lending policies in search of higher returns. Another example of moral hazard problem in banking industry is that bankers encourage borrowing which is not in the customers best interest. In many business, bankers act as both lenders and financial advisers for their customers because of their financial expertise. Cases such as bankers provide advises in their own best interest rather than customers can be found. In many banks incentive systems, bankers can get bonus by lending more to customers, but will get no or an insignificant amount of penalties when the lending is not beneficial to customers or the debt cannot be collected. This would probably result in customers or banks losses which has little impact on the bankers’ individual benefits.
Similar examples can be found in management area. Managers who act on the behalf of shareholders to operate the companies would take risky and short-term oriented strategies which could maximize their own benefits at the cost of shareholders. Managers whose payment is related to the company’s profit would possibly carry out operation policy which would increase the profit within his employment period but might not create shareholders wealthy in the long run; some managers who hold the company’s stock option might try to boom the stock price by fraud. These are all considered as moral hazard problems which come from the agency problem and the asymmetric information. The most famous example is probably the fall of Enron in which not only the governance and incentive of management were involved, auditing, fund management and financial analysts also played a part which can be considered immoral in this case.