A moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both parties have incomplete information about each other.
In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender’s point of view because they make him less likely to pay back a loan.
It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.
You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra care and attentiveness. You will install high-tech burglar alarms and hire watchmen to avoid any unforeseen events.
But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.
Overcoming Moral Hazard
1. Build in incentives
To avoid moral hazards in insurance, the insurance firm will design a contract to give you an incentive to make you insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first 10 or 15 percent of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.
2. Penalise bad behavior
The government could bail out banks, but penalize those responsible for making reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity.
3. Split up banks so they are not too big to fail
In the case of the global financial crisis of 2008, it was big banks that failed. The problem occurs when banks with consumer savings also take on risky investments. It is a risky investment that needs a bailout.
4. Performance related pay
To avoid the moral hazard in the labour market, there can be some form of performance evaluation and no guarantee of a job for life.