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The use of the term ‘moral hazard’ has a history of more than 200 years. As Dembe and Boden (2000) showed that, since the 1600s, the term ‘moral hazard’ is used in the discussion about the possibility of incentives for people under insurance to be less careful to protect themselves or insured goods and the tendency of fraud for obtaining financial benefits from insurance. It first appeared in the economic literature in the 1960s in terms of decision-making under uncertainty. Arrow (1963) and Pauly (1968) are two frequently quoted papers. Arrow (1963) considered moral hazard as one of the problems in the insurance market and pointed out that the assumption that insured events are taken place out of the control of insured individual is not really true in the real life and, therefore, there is not complete insurance market if the uncertainty exits. Pauly (1968) also explained that the moral hazard problem can be analyzed by orthodox economic tools in different kinds of insurance.
In the economic literature nowadays, moral hazard is studied in various fields. Dembe and Boden (2000) concluded that there are two major categories of researches on moral hazard. One is originated from the early literature about insurance market; the other is about economic decision-making, such as finance, banking, accounting and management.
In the current financial crisis, moral hazard is more frequently discussed and blamed as one of the causes of the banking problem. Summers (2007) claimed that the problem of moral hazard is overrated and warned people be aware of ‘moral hazard fundamentalism’. Dowd (2009) disagreed and believed that the problem is underrated and should be taken seriously. Dowd discussed the policy failures in the US financial industry in regards of moral hazard. Dow (2010) analysed the concept of moral hazard in relation to the financial crisis and concluded that there is immoral behaviour in financial market but the problem should go further than conventional understanding.
The rest of the essay is organised as follows. In the second section, the definitions and nature of moral hazard are discussed. In section three, examples will be provided and analysed. I will also describe the ways to overcome these problems in the fourth section.
2. What is Moral Hazard?
Moral hazard is defined in various ways in different aspects. The earliest explanation is from the perspective of insurance sector. Marshall (1976) provided the definition as ‘any misallocation of resources which results when risks are insured with normal insurance contracts and only with such contracts’. Briefly, moral hazard as the risky behaviour an insured individual may act because of the insurance cover.
There are two kinds of moral hazard in insurance field. One of them is ex ante moral hazard, which is the risky behaviour itself. In this situation, the insured will act risky, which results in more payment by the insurer for the negative consequence. The other one is ex post moral hazard. This is the type of behaviour that people change their reaction of risk when insurance is provided or enlarged to cover their cost.
Moral hazard can be also explained in terms of agent-principle problem. Dowd (2009) defined moral hazard as the potential behaviour that one party who is in the behalf of another party puts his own interest first. This definition is often used in management area. It is considered as the consequence of asymmetric information. Michael Parkin (2010) explained this as follows:
In some markets, either the buyers or the sellers- usually the sellers- are better informed about the value of the item being traded than the person on the other side of the market. Information about the value of the item being traded that is possessed by only buyers or sellers is called private information. And a market in which the buyers or sellers have private information has asymmetric information. Asymmetric information causes two problems: adverse selection and moral hazard. Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less-informed party.
3. Examples of Moral Hazard
There are many cases about the moral hazard problem in insurance market. An example provided by Stiglitz (1997) is about the auto insurance in New Jersey. In the 1980s, New Jersey was considered to have the worst problem on auto insurance. It had no upper limit on the medical costs that could be claimed from any accident and the state even provided auto insurance, Joint Underwriting Authority (JUA), to drivers who are too risky to get insurance from private companies at a similar rate for the less risky drivers. The state suffered a big loss by its insurance policy. The traffic accident rate and car theft rate were much higher than most of other states. Drivers took more risky behaviour when they are insured against medical treatments and car theft. The JUA had accumulated a $3 billion deficit at the end of the 1980s and extra taxed were needed to cover the loss which brought big problem to the government.
In finance and banking industry, moral hazard also can be found in various cases. ‘Too big to fail’ banks’ speculative investment banking activities are guaranteed by the government, because their failure will influent the whole economy. The belief that they will always be rescued from collapse causes these big banks to take greater risks in their lending policies in search of higher returns. Another example of moral hazard problem in banking industry is that bankers encourage borrowing which is not in the customers best interest. In many business, bankers act as both lenders and financial advisors for their customers because of their financial expertise. Cases such as bankers provide advises in their own best interest rather than customers’ can be found. In many banks’ incentive systems, bankers can get bonus by lending more to customers, but will get no or an insignificant amount of penalties when the lending is not beneficial to customers or the debt cannot be collected. This would probably result in customers’ or banks’ losses which has little impact on the bankers’ individual benefits.
Similar examples can be found in management area. Managers who act on the behalf of shareholders to operate the companies would take risky and short-term oriented strategies which could maximise their own benefits at the cost of shareholders. Managers whose payment is related to the company’s profit would possibly carry out operation policy which would increase the profit within his employment period but might not create shareholders’ wealthy in the long run; some managers who hold the company’s stock option might try to boom the stock price by fraud. These are all considered as moral hazard problems which come from the agency problem and the asymmetric information. The most famous example is probably the fall of Enron in which not only the governance and incentive of management were involved, auditing, fund management and financial analysts also played a part which can be considered immoral in this case.
4. Some Further Discussion
In this section, after taking examples of moral hazard problem from different aspects, what they have in common are discussed. The question why moral hazard is considered as a problem will be analysed and possible solutions to these examples are also be provided.
(1) Common features and negative consequence of moral hazard
First of all, at least two parties are involved. In the examples of insurance, the two parties are the insurer (insurance companies or the state) and the insured party. In the banking examples, the problem is between banks and the state or bankers and customers. And in terms of management, it comes to agent (managers) and principle (shareholders).
Secondly, one party’s interest is guaranteed, which encourages taking higher risk. The loss of the insured party can be partly covered by the insurance no matter how risky his behaviour is. Similar feature is showed in the cases of banking and management, although they do have some risk management system to limit the risk within certain extent.
Additionally, the highly risky behaviour of one party is difficult to or cannot be controlled by the other party. An auto insurance provider is impossible to control every insured driver’s driving speed. Not all customers of banks and shareholders of companies have a clear view of what their agent (bankers and managers) are doing because of lacking private information and professional knowledge.
What’s more, these moral hazard problems result in the cost of others and could lead to misallocation of social resources. The case of New Jersey auto insurance in the 1980s, the fall of Enron in 2001 and the recent banking crisis all caused huge social costs and brought economy problems.
(2) Can these problems be overcome?
Dowd (2009) suggested that measures that limit and eliminate moral hazard should be welcomed to reduce excessive risk-taking practice; and those create moral hazard should be avoid. Generally, a risk management system should be built.
For example, insurance companies insure one’s property up to a certain percentage of its replacement cost rather than fully cover it. Therefore, even if a big part of the risk is taken over, the insured party will still be worse off if bad thing happened. And this will encourage them to reduce their risk-taking behaviour. In Pauly (1968), deductibles and coinsurance are suggested to reduce the moral hazard. Deductible is an insurance in which an amount should be paid by the insured before the insurer will cover any expenses. Coinsurance is a sharing of risk between insurer and insured. Both methods aim to splitting and spreading the risk among the two or more parties involved in moral hazard problem.
In Dowd (2009), he argued that the state support should be removed from banking and banks should survive on their own strength in order to remove the moral hazard. However, this would not be possible in practice. More essentially, the size of ‘too big to fail’ banks should be cut down or controlled at a limited level.
Moreover, better performance measurement and incentive system should be introduced. Credit rating by bankers should be carried out more effectively and bankers should bear the risk of their behaviour and get penalties for bad debt at an amount that is high enough to warn them to avoid the excessive risk. In terms of management, long-term performance measurement should be taken from the shareholders’ perspective; regulations that require more transparent disclosure are also highly required.
In this essay, definition of moral hazard and examples from insurance, banking and management perspectives are discussed. The commons of these examples include the parties involved in the moral hazard, the uncontrollable risky behaviour of one party whose benefits are guaranteed and the social costs which the problem brings. Risk measurement and control system should be built to reduce moral hazard problem. Solutions such as risk-sharing insurance, significant penalties of bad debt and long-term performance measurement are suggested.
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