In business, moral hazard is the risk that any party takes in an attempt to make some profits before the contract is sealed. This party will not have entered into the contract in good faith hence might provide wrong information about its assets, liabilities and financial status.
It can also be addressed as what takes place when individuals alter their behavior and take more risks. This can take place when any two parties come into an agreement. It can occur if either of the following takes place:
- Presence of information asymmetry – This is where one party in a contract has more information than the other and is unwilling to share.
- When the contract affects the behavior of two different agents – this will occur especially if the two parties face different incentives. For instance, of you are insured, there will be less concern to guard against risks. In this case, moral hazard will occur in the insurance sector because if people are insured, they are kind of careless on their assets. Let us face it; the insurance company will always take care of it.
Examples of moral hazard
- Insurance and consumer behavior: We will start by taking two scenarios; first, if you have a bicycle and have not insured it, you will always take care of it and protect it from being stolen. However, if you have insured it fully, you will leave it outside the house unlocked as the insurance company will refund you the full amount. This is what we call asymmetric information in that the company will assume that you will good care of your bike while that is not the case for you.
- Moral Hazard and Sub Prime Mortgages: This occurs when the mortgages companies fail to follow up on the repayment of the mortgages since the bank takes all the risk. This will mostly take place if there is strong demand from people.
- Bank bailouts and moral hazard: This situation occurs between banks and the government. Normally, the government will not intervene if a manufacturing company becomes bankrupt. However, if a bank is on the verge of getting bankrupt, the government bails it out as it is the banking industry. In the end, the bank may change its behavior and take more risks.
- Fiscal and Monetary Union: A country in the European Union may assume that whenever it gets into financial problems, other countries will bail it out. This gives the country a chance to allow its debts to increase.
How can we deal with moral hazard?
Use of built-in incentives technique: This means that you have to be smart, especially at insurance firms. For instance, most insurance companies don’t allow you to insure assets like bicycles for the full amount. In addition, they make it difficult for you to claim your money. That way, you will protect your asset more.
Implementing Penalties for bad behavior, the government should penalize banks who are responsible for making any reckless decisions. In case of Union countries, the bailouts should be given under strict conditions.