Moral Hazard in real life

The Oxford Dictionary defines Moral Hazard as “the Lack of incentive to guard against risk where one is protected from its consequences”. Simply put, this means that once an agent knows his actions will not have a negative outcome for his side he is more likely to engage in reckless behavior. A behavior he would avoid in a normal situation where he would bear the brunt of the impact.

Recently we have witnessed a series of bank bailouts in Portugal. BPN, BANIF and CGD (and now Novo Banco) were once relatively stable banks that had to be bailed out by the State. The justification for these bailouts is related to the consequences of allowing the bank to go bankrupt. There is always the fear of instability, unemployment and the always looming danger of dragging other banks and triggering the collapse of the financial system. The problem with these government bailouts, apart from the obvious waste of tax-payer money that could be used elsewhere, is related to incentives. Once the Government clearly states its intention to save any faulty bank, other banks now have an incentive to engage in irresponsible behavior knowing fully well their actions are now insured. This will inevitably create a vicious cycle of irresponsibility-bailout-irresponsibility that will remove the credibility of a nation’s banking sector and will serve as black hole for tax-payer money.

The best analogy for this is the poker player. Let’s imagine a gambler at a casino playing a game of poker knowing fully well that in case he loses, his friend, who is right beside him, will return all of his lost money. In case he wins, he will get to keep all the profit. In this situation, it is not hard to imagine how the gambler would play versus how he would play in a situation where his friend is not there to return his money. This is the situation in which we place our banks. Even the most moral of bankers will have an incentive to risk more since he knows fully well his competition will probably do so.

This problem has persisted for a while and the solutions proposed are many as this is a rather lively debate among the public. Some defend that we must allow one bank to fail regardless of the consequences, so as to show the other banks what can happen if they keep engaging in such thoughtless behavior. This is sure to remove all the incentives, but the cost might be quite high for some economies to incur. Others defend that increasing regulations and supervision over the sector will be more than enough to fine-tune the banking system. And there are even many economists who defend that we shouldn’t do anything and that this is a “necessary evil” that we must live with and that any alternative would be catastrophic. In the end, apart from some macroprudential regulation measures, not much has been made to counter this as the Governments keep pumping money into faulty banks hoping to have a break to recover before the next collapse.

To conclude, while there are numerous cases of moral hazard, such as in the car insurance market, the banking case is probably one of the most vivid and important examples. Our economy depends a lot on banks and figuring out how to remove the incentives for careless behavior is one of the great challenges of our time. Maybe with new technology we are able to implement better controls over the system or maybe we just have to live with it like many propose. Regardless, it is an interesting topic, not only in economic but also in philosophic terms, that affects all of us and we should at least have an opinion regarding this issue.

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