Why do moral hazard problems exist

For example, in a recent speech about regulating the financial system, Federal Reserve chairman Ben Bernanke said , "As we try to make the financial system safer, we must inevitably confront the problem of moral hazard. That would make the system too expensive to sustain. Moral hazard is a term describing how behavior changes when people are insured against losses.

If, for example, your car is fully insured against any and all damage and there is no deductible, then you would have no incentive to avoid minor accidents, like scratches or backing into poles, beyond the inconvenience of getting the car fixed. You would be much more likely to take risks that could lead to minor car damage knowing that any damage is fully covered.

In this definition of moral hazard, the term "insurance" should be interpreted broadly. Insurance refers to anything that insulates an individual from harm, it isn't necessarily something that must be purchased from an insurance agent.

For example, wearing a bike helmet offers some insurance against serious head injury and might induce a cyclist to take more risks that could lead to a fall.

Or, as another example, an individual might be willing to try walking on a rope suspended high in the air if there is a safety net that is sure to offer protection, but if there is no net the individual might not be so willing. How does this apply to the financial sector? If the government is forced to bail out "too big to fail" banks to avoid catastrophic consequences for the entire economy, then bankers effectively have government insurance against losses.

Health Insurance. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Personal Finance Insurance. What Is a Moral Hazard? Key Takeaways A moral hazard is an idea that a party protected from risk in some way will act differently than if they didn't have that protection.

In the insurance industry, moral hazard occurs when insured parties take more risks knowing their insurers will protect them against losses. Considered to be too big to fail, banks often take additional financial risks knowing they'll be bailed out by the government. Because purely free-market capitalism doesn't exist, taxpayers end up footing the bill for moral hazards committed by large corporations.

Why Is Moral Hazard Important? What Are Examples of Moral Hazards? What Causes Moral Hazard in Insurance? Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Related Terms Risk Shifting Risk shifting is the transfer of risk s from one party to another party. Risk-Based Deposit Insurance Risk-based deposit insurance includes premiums that reflect how prudently banks behave when investing their customers' deposits.

Popular Courses. Economics Behavioral Economics. Table of Contents Expand. Understanding Moral Hazard. Great Recession. Salesperson Compensation. Moral Hazard in Insurance. Key Takeaways Moral hazard is a situation in which one party engages in risky behavior or fails to act in good faith because it knows the other party bears the economic consequences of their behavior.

Moral hazard can occur when governments make the decision to bail out large corporations. Bailouts send a message to executives at large corporations that any economic costs from engaging in excessively risky business activities in order to increase their profits will be shouldered by someone other than themselves. When a business owner pays a salesperson a set salary, that salesperson may have an incentive to put forth less effort, take longer breaks, and generally have less motivation to increase their sales numbers than if their compensation was tied to their sales numbers.

In general, those who pay the costs have limited information about the other party they are transacting with: the risky party. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.

Investopedia does not include all offers available in the marketplace. Related Articles. Insurance What Is a Moral Hazard? Behavioral Economics Moral Hazard vs. Morale Hazard: What's the Difference? Insurance Comparing Peril vs. Hazard in the Insurance Industry. Partner Links. Related Terms Risk Shifting Risk shifting is the transfer of risk s from one party to another party.

Risk-Based Deposit Insurance Risk-based deposit insurance includes premiums that reflect how prudently banks behave when investing their customers' deposits. Adverse Selection Adverse selection refers to the tendency of high-risk individuals obtaining insurance or when one negotiating party has valuable information another lacks.

Contract Theory Contract theory is the study of how individuals and businesses construct and develop legal agreements, drawing on economic behavior and social science to understand behaviors. Bailout Money Helps Failing Businesses and Countries A bailout is an injection of money from a business, individual, or government into a failing company to prevent its demise and the ensuing consequences.

Monopolistic State Fund A monopolistic state fund is a government-owned and operated fund set up to provide a mandatory insurance service in certain states and territories.