Moral Hazard

What Is Moral Hazard?

Moral hazard is the tendency of people or institutions to take on more risk when they are shielded from the full consequences of that risk. In finance, it arises when a party believes it will be rescued or insured if its bets go wrong, weakening its incentive to be cautious. The concern is common in debates over bailouts and deposit insurance: if lenders and executives expect a government backstop, they may lend and borrow more recklessly than they otherwise would. The idea appears across financial crises, from the savings and loan crisis to the 2008 rescue of large banks and the emergency loans of the 1997 Asian crisis.

Why It Matters

Moral hazard matters because it sits at the heart of a policy dilemma. Rescuing failing institutions can halt a panic and protect the wider economy, but it may also reward the very risk-taking that caused the trouble and encourage more of it next time. During the savings and loan crisis, federal deposit insurance protected savers yet let some thrift operators gamble with insured money. In 2008, emergency support for firms like AIG revived fears that too big to fail institutions could privatize gains while socializing losses. Regulators try to limit moral hazard through capital rules, supervision, and occasionally letting firms fail, balancing stability against accountability.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• The concern that bailing out large financial institutions encourages future excessive risk-taking is best described by what economic term?
  Moral hazard
• Debates over whether IMF and international lender support during the Asian crisis encouraged excessive risk-taking by borrowers and lenders alike center on what economic concept?
  Moral hazard
• Economists often cite federal deposit insurance for S&L accounts, while protecting depositors, as also contributing to what economic phenomenon by encouraging excessive risk-taking by some thrift operators?
  Moral hazard