Moral Hazard
IntermediateMoral hazard is the tendency for people or organisations to take greater risks when they are protected from the consequences of those risks, for example by insurance, guarantees or the expectation of a rescue.
When someone else bears the cost of a bad outcome, the person making decisions may become less careful. This creates moral hazard.
In insurance, a person with comprehensive car insurance might drive less carefully or take fewer precautions against theft, knowing that the insurer will pay for most losses. Insurers reduce this risk through excesses, which require the policyholder to pay part of each claim, and by adjusting premiums based on claims history.
In finance, moral hazard is a major concern with banks. If large banks believe the government will rescue them if they get into trouble, because they are too big to fail, they may take excessive risks, knowing they will keep the profits if things go well while taxpayers may bear the losses if things go badly.
Moral hazard is one reason regulators impose capital requirements on banks, why bailouts often come with tough conditions, and why deposit insurance has limits. Balancing protection against the risk of encouraging reckless behaviour is a constant challenge for policymakers.
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