8.4 Moral Hazard #Notebook

 8.4 Moral Hazard #Notebook

Adverse selection is precontractual asymmetric information. Moral hazard is postcontractual asymmetric information. 

Moral Hazard occurs whenever a borrower or insured entity engages in behaviors that are not in the best interest of the lender or insurer. 

If a borrower uses a bank loan to buy lottery tickets instead of Treasuries, as agreed upon with the lender, that’s moral hazard. 

If an insured person leaves their car unlocked or lets candles burn all night unattended, that’s moral hazard. 

It’s moral hazard if a borrower fails to repay a loan when he has the wherewithal to do so, or if an insured driver fakes an accident.

We all have a price, offered enough money, every human being will engage in immoral activities if given the chance. 

It’s tempting indeed to put other people’s money at risk. However, if the rewards come, the principal and interest are easily repaid. If the rewards don’t come, the borrower defaults and suffers but little. 

Not everyone defaults on a loan due to moral hazard. Bad luck, a soft economy, or poor execution can turn the best business plan to mush. 

A locked door can keep an honest man honest. Don’t try to tempt people. 

Monitoring? No matter how well they have screened (reduced adverse selection), lenders and insurers cannot contract and forget. 

Similarly, insurers long ago learned that they should insure only a part of the value of a ship, car, home, or life. That is why they insist on deductibles or co-insurance. If an accident will cost you $500 (deductible) or 20 percent of the costs of the damage (co-insurance), you will think twice or thrice before doing something risky with your car.

Reducing moral hazard, financial intermediaries have advantages over individuals. Monitoring is not cheap. Economists sometimes refer to it as “costly state verification.” Economies of scale give intermediaries an upper hand. 

Specialization and expertise also render financial intermediaries more efficient than individuals at reducing moral hazard. Financial intermediaries can afford to hire the best legal talent to frighten the devil out of would-be scammers. 

Financial intermediaries have monitoring advantages over markets. Bondholder A will try to free-ride on Bondholder B, who will gladly let Bondholder C suffer the costs of state verification, and all of them hope that the government will do the dirty work. In the end, nobody may monitor the bond issuer.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.