A situation where an entity has incentive to take on more risk since the financial institution will not bear the full results of that risk. This is done in pursuit of excess profits believing that losses will be covered by someone else.
This can happen anytime two companies enter into an agreement. Whenever one party does not have to bear the full impact of the risk undertaken, moral hazard exists. The first party in the transaction can negatively affect the other.
The concept stems from not doing what is right but most beneficial. Hence we see the reference to morality.
It is common within the financial and insurance industries.
Example:
A borrower presents moral hazard to a lender due to the possibility that he or she might engage in activities negative to the lender. This will make the borrower less likely to pay back the loan.
We can see this with insurance. A homeowner might not act in the best interest of the property knowing the risk is being born by the insurer. Since someone else will pay for any negative results, the disincentive against the behavior does not exist.
Moral hazard, when undertaken by enough firms that are large enough, can present systemic risk to an economy. This happened in a number of noted economic crashes that stemmed from the financial sector.
The Great Financial Crisis saw mortgage originators obliterate the lending standards associated with mortgages. This meant that the risk was born by those who were buying the securities tied to these assets.
Since the mortgages were sold and placed into mortgage pools, i.e. mortgage backed securities, the lender was not on liable for any negative consequences. Under this scenario, the risk was shifted to the investors, often without realization of what was being presented. The lack of lending accountability was placed on the balance sheets of those buying the debt.
This became a global problem as the assets were sold to banks, insurance companies, and pension funds all over the world. When the securities started to implode, financial devastation was followed by economic implosion.
