Explainer: What is "moral hazard"?

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(MoneyWatch) The term "moral hazard"is heard frequently in discussions about how to reform the health care system and the financial sector. 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." And a recent Boston Globe editorial on Obamacare said, "There is the risk of moral hazard: People might sign up only when they are sick. That would make the system too expensive to sustain."

What is moral hazard?

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. This gives them the incentive to take more risks when they invest the money that is deposited with them, and that increases the chance of a financial crisis and that a bailout will be necessary.

In health care, just as people are less likely to take good care of a car when they have full insurance, and just as they would get the car fixed more often, people who have health insurance are less likely to avoid health risks. As a result, they will go the doctor and use other medical services more frequently. That has the potential to increase health care costs.

What is the solution to moral hazard?

The most popular solution to the moral hazard problem is to make people pay a share of the costs of hazardous or risky behavior. In auto insurance markets, this comes in the form of a deductible that forces the car owner to pay for minor damage in full and to pay a relatively large share of more costly damage. Since the car owner must pay for some or all of the damages, he or she is more likely to be a careful driver, less likely to park so close to other cars that the door gets nicked, less likely to take the car in for repairs and so forth.

Health insurance markets have a similar mechanism to offset the incentive to take on too much health risk and to use medical services excessively, co-pays for office visits and deductibles on charges for health care services.

In financial markets the mechanism for avoiding moral hazard is a bit different, but the principle is the same. The key is to make sure that those who are making the decisions about how to invest other people’s money face consequences if they make bad investments. If the government simply bails out too big to fail firms and makes them whole again whenever they take too much risk, the individuals won’t face large consequences for their actions and they will have no incentive to attenuate their risky behavior.

The Dodd-Frank financial reform law, enacted in 2010, attempted to solve this problem by giving regulators what is known as “resolution authority." Under this authority, large, systemically important banks must have plans drawn up in advance for an orderly resolution should they get in trouble. Thus, unlike in the past these banks will not be saved if they are in danger of failing. Instead, the orderly resolution plans will be executed, the banks will be allowed to fail and the bank managers who made the decisions that led to the trouble will be out of a job.

There is some question about whether the government will have the will to exercise this power when a giant bank is in trouble -- what if the orderly resolution plans don't work after all? But bank executives certainly face larger personal risks today from taking on excessively risky investments than they did in the past.

Whenever people are protected from the downside of their choices, they will tend to take on additional risk, sometimes excessively so. If taking on extra risk has the potential to impose costs on other people, or puts other people at risk in some way, such as in a financial system breakdown, then some mechanism is needed to temper the risk-taking and protect innocent bystanders from the consequences of morally hazardous behavior.

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