What is a moral hazard?
The risk that one party to an agreement will take greater risks, knowing that another party will bear the costs if the risk doesn’t pay off.
Where have you heard about moral hazards?
The term is common in the insurance industry. For example, if you choose not to insure your house, you may protect it from fire, flood or theft by installing additional warning systems and security measures. If you take out insurance, you may choose not to put these measures in place as, if disaster strikes, the insurance company will bear the cost.
What you need to know about moral hazards.
Moral hazard exists at all levels of the economy, from a contract between a borrower and lender to the relationship between banks and the government.
A moral hazard can occur if two parties to a contract face different incentives, or where one party holds more information than the other. For example, a lender selling subprime mortgages may know that the people taking out the loan are at risk of defaulting. If these mortgages are bundled and sold on to a bank, the bank may not be aware of the high risk of default.
Find out more about moral hazards.
The financial crisis of 2007-2008 was widely regarding as an example of moral hazard.