Moral Hazard the Term Moral Hazard Arises

Moral Hazard The term moral hazard arises out of a contractual agreement. When the terms of the contract serve as motivation for one of the parties to behave in a manner that is "contrary to the principles laid out in the agreement" (Investopedia, 2013). An example that is commonly used is when a salesperson is paid entirely on salary. The salesperson in that case has little direct incentive to perform according to the spirit of the contract, save for the threat of dismissal.

The deal assumes that both parties will act according to the spirit of the contract, but the way the contract is structured this is not necessarily the case. The concept of moral hazard is often applied to the financial industry. Most contracts are designed to prohibit moral hazard, but multiple hazards have been identified. For example, homeowners who found themselves in arrears or their homes under water might have received assistance. This creates a moral hazard.

Normally, when a borrower fails to repay a mortgage, there are penalties that are incurred. These include foreclosure or credit problems that could prohibit future borrowing and could harm one's employment chances (Pritchard, 2013). If these consequences are not seen through, the borrower may realize that there is no longer disincentive to default. Thus, the homeowner will realize that it is better for him or her to default, perhaps receive assistance, and remain in his or her home.

It has been argued that this particular form of moral hazard led to excessive borrowing during the run-up to the 2008 financial crisis. There were other forms of moral hazard at work in that crisis as well. Normally, financial institutions maintain limits as to the amount of credit that they are willing to give, and to whom. The reason is simple -- a mortgage in default is a financial loss to the institution. This loss, however, was mitigated during the crisis not once but twice.

The use of credit default swaps and other instruments to sell the risk associated with mortgage portfolios removed the risk to the lending institution. Because they profited from the loan, but did not bear the consequences of the default, these institutions were incentivized to increase lending, and to increase the riskiness of their portfolios.

Yet a third moral hazard emerged as well, when the government moved to bail out some struggling banks, under the doctrine of "too big to fail." Too big to fail is one of the most significant moral hazards in the financial system. Essentially, it is the recognition that the collapse of a major bank would a catastrophic effect on the banking system and from there the entire U.S. economy.

The bankers who knew this were willing to take unusually large risks in their portfolios, knowing that the costs of those risks would be paid by the American taxpayer (Dowd, 2012). Worse, the same bankers who acted in this manner were cashing significant bonuses for themselves during the good years, could barely restrain themselves from more bonuses even in 2008-2009 and have since resumed generous bonuses so quickly after the taxpayer bailouts.

The moral hazard is that the bankers benefit from taking excessive risk, knowing that they will not pay the cost. Financial observers note that many of the issues of moral hazard that were present during the crisis remain. The too big to fail doctrine not only remains intact, but was likely reinforced by the different bailouts and other government involvement in the banking industry. Indeed, the government is still working to clean up the mess in the economy -- again a cost not paid by the bankers for their actions.

The moral hazard in the banking industry still exists, in essentially unchanged form. Some smaller banks were allowed to go under, but enough were helped to maintain this problem. The particular hazard that comes with repackaging subprime securities and arcane derivative instruments has been dealt with to some limited extent with the Frank-Dodd Act, but financial institutions still retain some ability to repackage risky securities. As well, the government is essentially powerless to legislate anything with respect to the compensation structures paid by publicly-held corporations.

There is no evidence that executives -- or shareholders for that matter -- have learned anything about the moral hazard of the typical banker compensation structure. Even in consumer markets, the moral hazards present in the run-up to the crisis still exist. Home ownership and consumer debt are so critical to the U.S. economy in recent years that the government is unwilling to tackle these issues while the economy is in recession. The result is that the minute some good economic reports emerge, savings rates decline.

Today, the housing market is showing signs of life, and banks are starting to lend again. There are simply no controls in place -- free market or otherwise - to remove the moral hazard. Arguably, either a pure form of unregulated marketplace or a fully socialized banking industry (a la China) would do a better job of eliminating moral hazard that the hybrid of heavily-regulated capitalism we see in the banking industry today. There are limits as to what can be done with moral hazard.

From a public policy perspective, only the contributions that government makes to moral hazard can be addressed. For example, the doctrine of 'too big to fail' can be publicly repudiated. Such an announcement.