Moral hazard

In economic theory, moral hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

Theory

According to contract theory, moral hazard results from a situation in which a hidden action occurs.^[1] Quoting Bengt Holmström,

It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.^[2]

The name 'moral hazard' comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed, or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as they would like to be protected.

Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed, or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. But since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.

Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than hidden actions.

The same underlying problem of unobservable actions also affects other contexts, besides the insurance industry. It also arises in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it would in the absence of this protection.

Moral hazard problems also occur in employment relationships. When a firm is unable perfectly to observe the actions taken by its employees, it may be impossible to achieve efficient behavior in the workplace—for example, workers' effort may be inefficiently low. This is called the principal-agent problem, which is one possible explanation for the existence of involuntary unemployment.^[3] Similar problems may also occur at the managerial level, because owners of firms (shareholders) may be unable to observe the actions of a firm's managers, opening the door to careless or self-serving decision-making.

In insurance

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service—which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.

Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).^{[citation needed]}

A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post (after the event) moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.

Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.

Moral hazard has been studied by insurers^[4] and academics. See works by Kenneth Arrow,^[5][6][7] Tom Baker,^[8] and John Nyman.

John Nyman suggests that two types of moral hazard exist: efficient and inefficient moral hazard. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medial care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.

Insurance analysts sometimes distinguish moral hazard from a related concept they call morale hazard.

In finance

Economist Paul Krugman described moral hazard as: "...any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."^[9] Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return.^{[citation needed]} So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well, while being bailed out by the taxpayer if the investment turns out badly.

Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.^{[10][11][12][13]} According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last twenty-years, all were resolved by bail outs at taxpayer expense.^{[citation needed]}

Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."^[14]

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards, because without such limits borrowers may spend borrowed funds recklessly, leading to default.

Securitization of mortgages in America, beginning in 1983 at Salomon Brothers, was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the present^[when?] mortgage securitization system in the United States, many different debts of many different borrowers are piled together into a great big pool of debt, and then shares in the pool are sold to lots of creditors – which means that there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language that the papers that he/she signed were written in, or even that the paperwork exists and is in good order. Various people^[who?] suggest that this may have caused 2007–2008 subprime mortgage financial crisis.^[15]

In the period 1998-2007 regulators kept and published detailed statistics on the ethnicity and location of those receiving loans, but failed to pay similar attention to their credit worthiness, default rates or vulnerability to a housing downturn. The data that the regulators focused on was more relevant to politically mobilizing voting blocks in particular electorates than to keeping the financial system solvent.^{[citation needed]}

Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the 2007–2008 subprime crisis, however, national credit authorities – in the U.S., the Federal Reserve – assumed the ultimate risk on behalf of the citizenry at large.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior, since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout will prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.^[16][17][18]

In management

Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:

• When a manager has a secure position from which he or she cannot be readily removed.
• When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects.
• When funding and/or managerial status for a project is independent of the project's success.
• When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division.
• When a manager may readily lay blame on an innocent subordinate.
• When there is no clear means of determining who is accountable for a given project.

The software development industry has specifically identified this kind of risky behavior as a management anti-pattern, but it can occur in any field.

• When senior management has its own remuneration as its primary motivation for decision making (ex. hitting short term quarterly earnings targets or creating high medium term earnings, without due regard for the medium term effects on, or risks for the business, so that large bonuses can be justified in the current periods). The shielding occurs because any eventual hit to earnings can most likely be explained away, and in the worst case, if an executive is terminated, usually the executive keeps the high salary and bonuses from years past.

• When a numbered company is used for construction projects as a subsidiary of a larger enterprise. For example: a numbered company is incorporated to construct a condominium in Vancouver. It is built to meet the minimum building code requirements, but is not designed for Vancouver's typical weather patterns (mild temperatures, lots of moisture). A few years later, the exterior cladding of the building is disintegrating with mold and rot. The numbered company that built it has no assets, so the condominium owners must suffer a large expense to rebuild it. In this scenario, the senior officers of the numbered company and its shareholders used the protection of a numbered limited liability company in order to take higher risks in the design and construction. Unless the law and the regulators have some effective means to hold those responsible to account, the Moral Hazard would be expected to continue to future building projects.

In extreme cases, moral hazard can lead to or permit control fraud to occur, where actual illegal activities take place.

History of the term

According to research by Dembe and Boden,^[19] the term dates back to the 17th century, and was widely used by English insurance companies by the late 19th century. Early usage of the term carried negative connotations, implying fraud or immoral behavior (usually on the part of an insured party). Dembe and Boden point out, however, that prominent mathematicians studying decision making in the 18th century used "moral" to mean "subjective", which may cloud the true ethical significance in the term.^[20]

The concept of moral hazard was the subject of renewed study by economists in the 1960s, and at the time did not imply immoral behavior or fraud; rather, economists use the term to describe inefficiencies that can occur when risks are displaced, rather than on the ethics or morals of the involved parties.

See also

• Conflict of interest
• Externality
• Feedback
• Free rider problem
• Game theory
• Information economics
• Offset hypothesis
• Perverse incentive
• Samaritan's dilemma
• Systemic risk
• Unintended consequence

References

1. ^ A. Mas-Colell, M. Whinston, and J. Green (1995), Microeconomic Theory. Chapter 14, 'The Principal-Agent Problem', p. 477.
2. ^ Holmstrom, B. (1979), "Moral hazard and observability". Bell Journal of Economics, pp. 74-91.
3. ^ C. Shapiro and J. Stiglitz (1984), 'Equilibrium unemployment as a worker discipline device'. American Economic Review 74 (3), pp. 433-444.
4. ^ Crosby, Everett (1905). "Fire Prevention". Annals of the American Academy of Political and Social Science (American Academy of Political and Social Science) 26 (2): 224–238. doi:10.1177/000271620502600215. JSTOR 1011015.  Crosby was one of the founders of the National Fire Protection Association, NFPA.org
5. ^ Arrow, Kenneth (1963). "Uncertainty and the Welfare Economics of Medical Care". American Economic Review (American Economic Association) 53 (5): 941–973. JSTOR 1812044. 
6. ^ Arrow, Kenneth (1965). Aspects of the Theory of Risk Bearing. Finland: Yrjö Jahnssonin Säätiö. OCLC 228221660. 
7. ^ Arrow, Kenneth (1971). Essays in the Theory of Risk- Bearing. Chicago: Markham. ISBN 0841020019. 
8. ^ Baker, Tom (1996). "On the Genealogy of Moral hazard". Texas Law Review 75: 237. ISSN 0040-4411. 
9. ^ Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited. ISBN 978-0-393-07101-6. 
10. ^ Summers, Lawrence (2007-09-23). "Beware moral hazard fundamentalists". Financial Times. http://www.ft.com/cms/s/0/5ffd2606-69e8-11dc-a571-0000779fd2ac.html. Retrieved 2008-01-15. 
11. ^ Brown, Bill (2008-11-19). "Uncle Sam as sugar daddy". MarketWatch. http://www.marketwatch.com/news/story/story.aspx?guid={9F4C2252-8BA7-459C-B34E-407DB32921C1}&siteid=rss. Retrieved 2008-11-30. 
12. ^ Common (Stock) Sense about Risk-Shifting and Bank Bailouts. SSRN.com. December 29, 2009. SSRN 1321666. 
13. ^ Debt Overhang and Bank Bailouts. SSRN.com. February 2, 2009. SSRN 1336288. 
14. ^ Zandi, Mark (2009). Financial Shock. FT Press. ISBN 978-0-13-701663-1. 
15. ^ Holden Lewis (2007-04-18). "'Moral hazard' helps shape mortgage mess". Bankrate.com. http://www.bankrate.com/brm/news/mortgages/20070418_subprime_mortgage_morality_a1.asp?caret=3c. Retrieved 2007-12-09. 
16. ^ David Wighton (2008-09-24). "'Paulson bailout: seizing moral high ground can be hazardous'". TimesOnline. http://business.timesonline.co.uk/tol/business/columnists/article4813975.ece. Retrieved 2009-03-17. 
17. ^ HFM (2009-03-16). "'The SEC Makes Wall Street More Fraudlent'". Justput.com Post # 17-26. http://www.justput.com/forum/showthread.php?t=6820. Retrieved 2009-03-17. 
18. ^ Frank Ahrens (2008-03-19). "Moral Hazard': Why Risk Is Good'". The Washington Post. http://www.washingtonpost.com/wp-dyn/content/article/2008/03/18/AR2008031802873.html. Retrieved 2009-03-17. 
19. ^ Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?" New Solutions 2000 10(3). 257-279
20. ^ David Anderson, Ph. D. "The Story of the moral"

• JSTOR.org, A working link to the Everett Crosby article "Fire Prevention"
• JSTOR.org, A working link to the Kenneth Arrow article "Uncertainty and the Welfare Economics of Medical Care"

External links

• Pezzuto, Ivo (2008). Miraculous Financial Engineering or Toxic Finance? The Genesis of the U.S. Subprime Mortgage Loans Crisis and its Consequences on the Global Financial Markets and Real Economy, ISSN 1662-761X. In this paper Prof. Prof. Pezzuto explained the root causes of the financial crisis, first introduced the term short-termism associated to the 2008 financial crisis, and predicted the risk of a EU peripheral debt crisis. Available online SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1332784
• Pezzuto, Ivo (2010). The miracle still goes on for someone, available on Baseline Scenario: http://baselinescenario.com/2010/01/18/the-%E2%80%9Cmiracle%E2%80%9D-still-goes-on-for-someone%E2%80%A6/
• Pezzuto, Ivo (2010). Miraculous Financial Engineering or Legacy Assets? on Robert W. Kolb's book Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future ,ISBN: 978-0-470-56177-5. Publisher: Wiley (June 8, 2010) http://eu.wiley.com/WileyCDA/WileyTitle/productCd-0470561777,descCd-tableOfContents.html
• Kolb, Robert (2010). “Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future” (Robert W. Kolb Series), Publisher: Wiley ISBN-10: 0470561777, ISBN-13: 978-0470561775
• Saintjoe.edu, Discussion of moral hazard and insurance by Robert Schenk
• Gladwell.com, The Moral Hazard Myth (in Health Care)
• TheBigMoney.com, What is Moral Hazard
• Press.illinois.edu, What's so Moral about the Moral Hazard?
• Marketwatch.com, Uncle Sam as sugar daddy; Marketwatch Commentary: The moral hazard problem must not be ignored
• PBS.org, Inside the Meltdown, PBS's Frontline episode uses the idea as a central theme
• Mises.org, A comparison of the conventional views of moral hazard, with that by Austrian economists