What is the problem of moral hazard?

Moral hazard is an economic term that refers to a situation where one party has the tendency to take more risks because another party bears the costs or consequences of those risks. It usually arises when there is information asymmetry between two parties, i.e., one party has more information about the potential risks and consequences than the other party. This can lead to suboptimal outcomes, as the party taking the risks has less incentive to act responsibly, knowing the negative consequences will fall on someone else.

The consequences of moral hazard can be detrimental as it can lead to a misallocation of resources and negative impacts on both parties involved. The party bearing the costs may face financial losses, while the party taking the risks can lose reputation or face legal consequences. Furthermore, moral hazard can lead to unnecessary risks being taken, which could have been easily avoided if the incentives for both parties were aligned.

A classic example of moral hazard is the financial crisis of 2007-2008. The crisis was partly caused by the actions of some banks and financial institutions engaging in risky lending practices with subprime mortgages. The banks and financial institutions were able to sell these mortgages to investors in the form of mortgage-backed securities. In this instance, the financial institutions had more information about the potential risks and the quality of these mortgages than the investors purchasing the securities. Thus, they were encouraged to take on greater risks in lending since they were not directly bearing the consequences of the risks they were taking. These risky practices eventually led to a significant number of mortgage defaults, causing the financial crisis.

In summary, moral hazard refers to a situation where one party has incentives to take more risks because the consequences of those risks will be borne by another party. This generally arises due to information asymmetry between the two parties, and it can lead to negative consequences for both parties involved. Understanding moral hazard is crucial for designing contracts, policies, and regulations that can mitigate these risks and incentivize responsible behavior.