The tendency to take greater risks when protected from consequences, because someone else bears the cost of failure
Moral hazard occurs when one party takes risks because another party bears the consequences. Insurance creates moral hazard: you drive less carefully when someone else pays for accidents. Bank bailouts create moral hazard: executives take excessive risks knowing taxpayers cover losses.
Core dynamic: When you separate risk-taking from risk-bearing, risk-taking increases. The person making decisions benefits from upside but doesn't suffer proportionally from downside. This asymmetry distorts behavior toward excessive risk.
Why it matters: Moral hazard explains seemingly irrational systemic failures:
Key distinction from adverse selection: Adverse selection is pre-contract information asymmetry (high-risk people buy more insurance). Moral hazard is post-contract behavior change (insured people become riskier).
Designing incentive structures:
Policy and regulation:
Investment and lending:
Organizational governance:
Map who bears consequences vs. who makes risk decisions:
Questions to ask:
Common patterns:
If the decision-maker's downside is capped while upside is unlimited, moral hazard exists.
Rate the strength of the distortion:
High moral hazard indicators:
Low moral hazard indicators:
Reduce moral hazard through alignment mechanisms:
Skin in the Game:
Deductibles and Co-pays:
Monitoring and Oversight:
Reputation and Career Consequences:
Limiting Protection:
Pure elimination of moral hazard eliminates beneficial risk-sharing:
The tradeoff: Insurance is valuable precisely because it absorbs risk. Removing all protection removes benefits. The goal is optimal moral hazard, not zero.
Calibration approaches:
Moral hazard grows when implicit guarantees become expected:
Warning signs:
Prevention:
2008 Financial Crisis: Moral Hazard Masterclass
The Setup:
The Behavior:
The Result:
Post-Crisis Reforms (Mixed Success):
Lesson: When you guarantee bailouts, you guarantee the behavior that requires them.
Assuming protection eliminates risk: Protection shifts risk, it doesn't eliminate it. Someone always bears the downside. Moral hazard determines who and how much.
Designing incentives without considering behavioral response: People respond to incentives. If you protect against loss, they'll take more risk. Plan for it.
Implicit guarantees: Worse than explicit guarantees because they create moral hazard without the ability to price or regulate it. "We never said we'd bail them out" doesn't prevent bailout expectations from forming.
Monitoring as substitute for alignment: Surveillance catches bad behavior after it happens. Proper incentive alignment prevents the behavior in the first place. Align first, monitor second.
Eliminating all moral hazard: Some risk-sharing is valuable. The goal is appropriate moral hazard where benefits exceed costs, not zero moral hazard.