Moral hazard refers to a situation in which a person has an incentive to behave in a risky manner for being somehow protected and not totally bearing the consequences of a bad decision herself. It arises from the existence of imperfect information regarding actions of people. Typically, moral hazard is illustrated through examples in the insurance industry where the risk-bearing influence on decisions is easy to understand – While too little insurance will mean a lot of risk borne by you, being totally reimbursed might relax you a little bit too much and result in careless behavior. Insurance companies are uncertain of how will you act once you get the insurance, but they know that much.
A much more pertinent application of the concept of moral hazard, for its implications in society as a whole, is to the financial markets. In particular, is it reasonable to expect moral hazard effects to arise from a bank bailout? Bailouts have been a recurrent topic in the past years and are justified as to avoid subsequent negative externalities, such as risk contagion or confidence crises. Banks are, in this sense, protected by a safety net – it is expected that one simply doesn’t let banks become insolvent given the severe and potentially systematic consequences of such event. This safety net, which can be made out of mere expectations about the likelihood of bailing out the bank if needed can create moral hazard in the form of imprudent risk-taking behavior by the bank managers, as the probability of the bank surviving will depend less on the bank’s choice of risky assets and more on the central bank and the government’s policies. The bank has, then, an incentive to allocate resources in riskier projects that maximize expected private profits but also accentuate the risk of insolvency.
This incentive can be partially mitigated through supervision and regulation. A concrete example is the EU Bank Recovery and Resolution Directive, adopted in April this year and coming into force in January 2015. This directive sets common measures for covering costs of bank rescues. In this case, we see that by “passing the buck” from taxpayers onto private investors, shareholders and debt holders, alongside with much more limited room for a temporary public intervention in case of a systemic threat, banks activities are subject to more discipline. Banks also lose incentive for being risky, as they must contribute to build the resolution fund themselves. Nonetheless, the BRRD does not fully eliminate moral hazard potential. By allowing each state to inject public funds in times of systematic crisis, richer countries can still bail out banks while poorer countries will bail in.
Creating a “perfect” incentive that fully offsets this or any moral hazard situation is difficult. A positive aspect, regardless, is that this directive requires higher clarity of all banks about how and where capital for bailing-in is being held. It also sheds light on how all recovery and resolution plans will be build, for they must comply with common norms. So incentives for not being risky are reinforced by unveiling important information about present and possible future actions, therefore reducing uncertainty.
Inês Gonçalves Raposo
Cordella, T., and E. L. Yeyati. 2003. Bank Bailouts: Moral Hazard vs. Value Effect. Journal of Financial Intermediation
Dam, L. and Koetter, M., 2012. Bank Bailouts and Moral Hazard: Evidence from Germany, The Review of Financial Studies/v 25 n 8