Moral Hazard
Term: Moral Hazard | Book: Lipstick on a Pig (financial bailouts): book profile and conceptual summary
Definition and core idea
Moral hazard arises when an actor, because they are protected against part of the harmful consequences of their decision, has a greater incentive to take on risk.
Explanation and elaboration
In banking, if managers or funders believe that public support will certainly come in a crisis, the pricing of risk, market discipline or prudential capital may not work properly. This expectation can be explicit or implicit.
This concept does not mean that every emergency aid automatically creates moral hazard. How the support is designed matters: absorption of losses by shareholders, a change of management where needed, restructuring conditions, oversight, limits on bonuses and the possibility of orderly resolution can all change incentives.
Notes and limits of interpretation
Separating claim from fact
Moral hazard is an incentive mechanism, not automatic proof of bad behaviour by any bank or manager. To judge, you have to examine the structure of contracts, market expectations and how actors responded.
Relations to other concepts
- Bank Bailouts
- Too Big to Fail (TBTF)
- Privatization of Gains and Socialization of Losses
- Orderly Resolution of Failing Banks
Review questions
- What problem does this concept clarify?
- Who benefits and who is harmed?
- What evidence is needed to test this claim in a real case?
- Which part is the author’s position and which part needs independent evidence?