Business regardless of how successful they are, often experience moral hazard. Moral hazard refers to a situation where a person or company will change their behavior to allow unnecessary risks because someone else will bear the cost of those risks. It is a conscious and deliberate change in behavior, with the result being increased probable frequency and severity of loss. The term was first coined by players in the insurance industry. The insured may withhold some information about his intentions from the insurer. An example is a car owner who becomes lax on securing his car because it is protected against theft. He may deliberately park in an area reputed to be insecure because he will receive some compensation in the case of car loss ( Rao, 2016).
Moral hazard is of concern to many financial institutions since it tends to reduce efficiency in the marketplace because of the cushioning that is guaranteed to an investor. Players in the industry are less motivated to succeed because they have a safety net to land on. Market observers argue that time will come when no C.E.O will bother to calculate risk versus profit if they are guaranteed to be bailed out in case something goes wrong. If this prediction materializes, then bailouts will increase in magnitude and frequency to the extent of being unsustainable (Barth & Kaufman, 2015).
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For the past decade, most financial institutions were often eager to lend money for mortgages. They sometimes give money to risky borrowers, in the confidence that they were too big for the government to let them fail. When the financial crisis hit, the government decided to help out mortgage holders who were unable to meet their payments. This move was to cushion investors while helping out the homeowners. Many people took the easy way out and stopped making payments even when they were able to. This was a loss to both the investors and the government (Barth & Kaufman, 2015).
Therefore, to reduce the dependence on moral hazard, the policies should be reviewed to spread the risk between the parties. For instance, In auto insurance companies, it comes as a deductible that will compel the owner to cater for any minor damaged incurred on their car. In financial markets, the key decisions of makers on investments should be held responsible for the kind of investments they engage with people’s money. If taking additional risk that will negatively impact on clients such as in a financial breakdown, then it is important that some mechanism is put in place to protect the innocent investors from the penalties of hazardous moral behavior. This will force sober decisions and players in the financial sector will act responsibly. Incentives that are more attractive than the cushioning will also encourage better outcomes and a gradual reduction in moral hazard.
References
Barth, J. R., & Kaufman, G. G. (2015). The first great financial crisis of the 21st century: A retrospective. New Jersey: world Scientific Press.
Rao, T. V. S. R. (2016). Risk Sharing, Risk Spreading and Efficient Regulation . New Delhi: Springer India Press.
