What is Moral Hazard?

Moral Hazard

In economics Moral Hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk. Economist Paul Krugman described moral hazard as: "...any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."

The theory is that people behave differently if someone else bears the adverse consequences of a poor decision. The theory originated in the insurance industry where it was thought that people are likely to be less careful if they are insured against loss. So people may not be so careful to lock their house if they have insurance against being burgled.

In the finance markets the theory is that if there is a Government guarantee or a "lender of last resort facility", lenders will take higher risks because if the worst comes to the worst someone else will bail them out.

Some economist believe that the root cause of the whole global financial crisis was caused by moral hazard as lenders became less and less careful about who they loaned money to as the lenders were always going to sell the loan to someone else.

If you want to read up more on moral hazard Wikipedia is a good place to start, click here http://en.wikipedia.org/wiki/Moral_hazard.

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