What is moral hazard problem?

The financial crisis of 2007 brought many adverse trends in the banking sector globally.  One such trend was what we call as the moral hazard problem. Here, the banks have taken excessive risks. They knew that even if the bank fails as a result of excessive risk taking, rehabilitating such a big bank will be done by the government and the central bank to avoid adverse effect on the economy. This consciousness encourages them to take more risks.

The moral hazard problem arises when a party has a tendency to embrace more risk knowing that the cost of taking such a risk will not be borne by him. The knowledge that the cost of risk taking will be paid partly or wholly by others incentivizes risk taking.

Moral hazard arises because individuals or organizations which are taking risks don’t take full consequences or responsibilities of its own actions. Moral hazard usually is case of information asymmetries.

When there is information asymmetries, the risk taking individual/organization have more information compared to others. 

Nobel Prize winner in Economics, Paul Krugman is known for his studies on Moral Hazard problem. According to him, moral hazard is “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”

The large number of bank failures during the last financial crisis has activated debate on moral hazard problem. When the government and central banks are providing financial bailouts of failed institutions, it may encourage excessive risk taking in the belief that they will not have to carry the full burden of potential losses. In many western countries financial conglomerates have developed a notion called too-big to fail.

In the developed world, central banks and governments have taken group of measures to eliminate moral hazard among banks. In the US and UK, governments have introduced legislations to raise the capital of banks. Ring-fencing of banking activities, resolution plans and dividing big banks into different components etc made to end the problem of moral hazard.