moral hazard

Once your car is fully insured against theft, do you still bother locking it every single time? Once a bank knows the government will bail it out if it fails, does it gamble a little more boldly? In both cases, being shielded from the consequences of risk quietly makes people take more of it. That tendency to behave more recklessly when someone else bears the downside is moral hazard.

Moral hazard arises after a contract is signed, when one party can change their behaviour in a way the other cannot fully observe or control, and when they no longer fully bear the cost of that behaviour. The insurer cannot watch whether you lock the car; the bank's risky bets are hidden in complex books. Because the careful action is costly to the actor but its benefit now flows partly to someone else (the insurer, the taxpayer), the actor under-supplies care and over-supplies risk. Note the name is misleading — it is not about morality or bad character, but about incentives quietly shifting once risk is transferred.

Moral hazard is everywhere insurance, lending, employment, and bailouts appear. It explains deductibles and co-pays (make you keep some skin in the game), monitoring and performance pay at work, collateral requirements on loans, and the fierce debate over 'too big to fail' banks. The standard remedies all try to re-link action to consequence — by leaving the actor partly exposed to the downside, watching behaviour more closely, or rewarding good outcomes. It is a close cousin of the principal-agent problem and a direct child of asymmetric information.