Moral Hazard

Moral hazard is the term used to describe the situation where a party may act more prudently if it knows it is not sheltered from the true risk of its actions. In other words, if a party knows that another party will act to protect them, then the tendency is to be less careful – in this regard, moral hazard can apply to an individual or a company.

For example, if a university student knows that their parents will pay the rent should the student not have enough money remaining when the rent is due, the temptation may be to spend more money on frivolous items than their budget allows knowing they can count on family to pay the rent for them if necessary.

Likewise, a company such as a large bank may make a series of high-risk investments secure in the knowledge that the government will be forced to cover their losses rather than allow the bank to fail. For this reason, the risk of moral hazard is often quoted as the reason that governments should not directly interfere in the markets.