Moral Hazard

Key Highlights

• Moral hazard happens when people or companies take big risks because they know they won’t face the full consequences if things go wrong.

• Moral hazard can shake up financial markets, spark crises, and leave taxpayers stuck with the bill when things go south.

What is Moral Hazard in Finance

Moral hazard happens when people or companies take big risks because they know they won’t face the full consequences if things go wrong. It’s like playing a high-stakes game knowing someone else will cover your losses.

Why It Happens?

• Safety Nets: Things like government bailouts or insurance protect against losses, so risks feel less scary.

• Tempting Rewards: Taking bigger risks can lead to bigger profits, especially if someone else pays for failures.

• Hidden Information: The risk-taker often knows more about their actions than those who might end up footing the bill, like taxpayers or investors.

Real-World Examples

• 2008 Financial Crisis: Banks made risky loans, betting that the government or others would save them if things crashed—which they did with huge bailouts.

• AIG’s Risky Bets: AIG sold insurance on risky investments, assuming the government would step in if they couldn’t pay up.

• Bank Deposit Insurance: Knowing deposits are guaranteed, banks or customers might take chances they wouldn’t otherwise.

Why It Matters?

Moral hazard can shake up financial markets, spark crises, and leave taxpayers stuck with the bill when things go south.