Monday, January 28, 2008

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.
Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.
In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.
The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.


vansant said...

So what is the incentive for the investor to do "background checks" on the loaning bank? If the FDIC insures their investment and the bank is giving investors a better rate the average Billy Bankroll is not going to care. Yes if the bank closes it's gates and locks it's doors, the investor will have to wait until the FDIC gets their cash to them, but they did get a ton of cash for doing close to nothing.

So a CEO of a bank, let's call it "Grizzly Firm Bank," sees that his bank is in trouble. "We are going to raise our interest rates to intice bigger loans. This will inturn save our 'Grizzly Firm Bank.'"

However, this risk does not pay off for the CEO. What happens to the bank...the FED bails them out, repays the loans, and slaps "Grizzly Firm Bank" on the wrist. This wrist slap reverberates through the bank and the board wants head on the chopping block.
"The CEO is the man responsible for this. His head will be on a spike by the end of this!"

This sounds like it will end in bloodshed and tears for the CEO and it will. But the bloodshed will be in the form a a hefty severence and early retirement package and the tears will be tears of joy for evading possible jail time.

So, all is well that ends well.

TaDonne' said...

Moral hazard is a risky element in the business world. I think you have to take risks to gain, but at what cost. It seems these are the gambles that many businesses take all the time. It does help with customer/sales rep relationship. I guess it would establish a trust between the two.