The use of the word 'moral hazard' has a brief history of more than 200 years. As Dembe and Boden (2000) revealed that, because the 1600s, the word 'moral threat' is utilized in the talk about the probability of incentives for people under insurance to be less careful to protect themselves or insured goods and the tendency of fraudulence for obtaining financial benefits from insurance. It first came out in the economic books in the 1960s in terms of decision-making under doubt. Arrow (1963) and Pauly (1968) are two frequently quoted papers. Arrow (1963) considered moral risk as one of the problems in the insurance market and remarked that the assumption that covered by insurance events are taken place from the control of covered by insurance individual is not really true in the true life and, therefore, there isn't complete insurance market if the uncertainty exits. Pauly (1968) also described that the moral hazard problem can be examined by orthodox economical tools in various varieties of insurance.
In the monetary books nowadays, moral hazard is studied in various fields. Dembe and Boden (2000) concluded that there are two major categories of studies on moral hazard. One is originated from the early literature about insurance market; the other is approximately financial decision-making, such as fund, banking, accounting and management.
In the current financial meltdown, moral hazard is more frequently mentioned and blamed as one of the factors behind the banking problem. Summers (2007) said that the problem of moral risk is overrated and warned people be familiar with 'moral risk fundamentalism'. Dowd (2009) disagreed and thought that the situation is underrated and should be taken seriously. Dowd mentioned the plan failures in america financial industry in regards of moral threat. Dow (2010) analysed the concept of moral hazard with regards to the financial crisis and concluded that there is immoral behaviour in financial market but the situation should go beyond conventional understanding.
The remaining article is organised as follows. In the second section, the explanations and mother nature of moral hazard are talked about. In section three, samples will be provided and analysed. I am going to also express the ways to triumph over these problems in the fourth section.
2. What's Moral Risk?
Moral hazard is defined in various ways in different aspects. The earliest description is from the perspective of insurance sector. Marshall (1976) provided this is as 'any misallocation of resources which results when hazards are covered with normal insurance contracts and only with such deals'. Quickly, moral threat as the dangerous behaviour an covered individual may act due to protection plans.
There are two varieties of moral threat in insurance field. One of these is ex ante moral threat, which is the risky behavior itself. In this example, the covered will act high-risk, which results in more repayment by the insurance company for the negative effect. The other you are ex post moral risk. This is the sort of behaviour that folks change their result of risk when insurance is provided or enlarged to protect their cost.
Moral hazard can be also explained in conditions of agent-principle problem. Dowd (2009) identified moral hazard as the potential behaviour the particular one party who's in the behalf of another get together places his own interest first. This definition is often found in management area. It really is considered as the consequence of asymmetric information. Michael Parkin (2010) explained this as follows:
In some markets, either the clients or the vendors- usually the retailers- are better enlightened about the value of that being traded than the person on the other side of the market. Information about the worthiness of the item being bought and sold that is possessed by only purchasers or sellers is called personal information. And market in which the buyers or sellers have personal information has asymmetric information. Asymmetric information triggers two problems: adverse selection and moral hazard. Moral hazard is the trend for folks with private information, after getting into an agreement, to make use of that information for his or her own benefit and at the expense of the less-informed get together.
3. Examples of Moral Hazard
There are numerous instances about the moral hazard problem in insurance market. An example provided by Stiglitz (1997) is approximately the auto insurance in New Jersey. In the 1980s, NJ was thought to have the most detrimental problem on automobile insurance. It got no upper limit on the medical costs that might be claimed from any mishap and the state of hawaii even provided auto insurance, Joint Underwriting Power (JUA), to individuals who are too risky to get insurance from private companies at an identical rate for the less high-risk drivers. The state of hawaii suffered a large loss by its insurance coverage. The traffic automobile accident rate and car robbery rate were much higher than most of other states. Motorists took more dangerous behavior when they are covered with insurance against procedures and car fraud. The JUA experienced accumulated a $3 billion deficit by the end of the 1980s and further taxed were had a need to cover the loss which helped bring big problem to the government.
In fund and bank industry, moral risk can also be within various instances. 'Too big to are unsuccessful' finance institutions' speculative investment banking activities are assured by the government, because their failure will influent the whole economy. The belief that they will continually be rescued from collapse causes these big lenders to take increased dangers in their loaning policies in search of higher returns. Another example of moral risk problem in banking industry is the fact bankers encourage borrowing which is not in the customers best interest. In many business, bankers act as both lenders and financial advisors for his or her customers for their financial expertise. Cases such as bankers provide advises in their own best interest somewhat than customers' are available. In many lenders' motivation systems, bankers can get bonus by financing more to customers, but are certain to get no or an insignificant amount of fines when the lending is not beneficial to customers or the debt cannot be accumulated. This might probably bring about customers' or banking institutions' losses which includes little effect on the bankers' individual benefits.
Similar examples are available in management area. Managers who react on the behalf of shareholders to use the firms would take risky and short-term focused strategies that could maximise their own benefits at the cost of shareholders. Professionals whose payment is related to the company's income would possibly perform operation coverage which would boost the income within his occupation period but might not create shareholders' rich over time; some professionals who contain the company's stock option might make an effort to boom the stock price by fraud. They are all regarded as moral threat problems which come from the firm problem and the asymmetric information. The most well-known example is just about the fall of Enron where not only the governance and incentive of management were involved, auditing, fund management and financial experts also played a part which may be considered immoral in cases like this.
4. Some Further Discussion
In this section, after taking types of moral threat problem from different facets, what they have as a common factor are reviewed. The question why moral threat is recognized as a challenge will be analysed and possible solutions to these examples are also be provided.
(1) Common features and negative outcome of moral hazard
First of all, at least two gatherings are involved. Inside the types of insurance, both parties will be the insurer (insurance companies or the talk about) and the insured party. Within the banking examples, the problem is between banking companies and their state or bankers and customers. And in terms of management, it involves agent (managers) and basic principle (shareholders).
Secondly, one party's interest is guaranteed, which encourages taking higher risk. The loss of the insured get together can be partly included in the insurance no matter how risky his behaviour is. Similar feature is demonstrated in the instances of bank and management, although they do involve some risk management system to limit the risk within certain magnitude.
Additionally, the highly high-risk behaviour of one party is difficult to or cannot be handled by the other get together. An auto insurance carrier is impossible to control every insured driver's driving quickness. Not absolutely all customers of finance institutions and shareholders of companies have a definite view of what their agent (bankers and professionals) are doing because of missing personal information and professional knowledge.
What's more, these moral risk problems cause the cost of others and may lead to misallocation of social resources. The case of NJ auto insurance in the 1980s, the fall of Enron in 2001 and the recent banking crisis all induced huge cultural costs and helped bring overall economy problems.
(2) Can these problems be conquer?
Dowd (2009) suggested that options that limit and eliminate moral risk should be welcomed to lessen abnormal risk-taking practice; and those create moral risk should be avoid. Generally, a risk management system should be built.
For example, insurance firms insure one's property up to a certain percentage of its substitution cost rather than completely cover it. Therefore, even if a major part of the risk is bought out, the insured get together will still be worse off if bad thing happened. And this will cause them to become reduce their risk-taking behavior. In Pauly (1968), deductibles and coinsurance are suggested to reduce the moral threat. Deductible is an insurance where a quantity should be paid by the covered by insurance before the insurance company covers any expenditures. Coinsurance is a sharing of risk between insurer and covered by insurance. Both methods try to splitting and dispersing the risk among the two or more functions involved in moral threat problem.
In Dowd (2009), he argued that the state support should be removed from banking and banking companies should survive on their own strength to be able to eliminate the moral threat. However, this would not be possible in practice. More essentially, how big is 'too big to are unsuccessful' bankers should be cut down or managed at a limited level.
Moreover, better performance way of measuring and incentive system should be created. Credit history by bankers should be carried out better and bankers should carry the risk of the behavior and get fines for bad arrears at a quantity that is high enough to warn them to prevent the unnecessary risk. In conditions of management, long-term performance dimension should be studied from the shareholders' point of view; regulations that require more clear disclosure are also highly required.
In this essay, explanation of moral threat and illustrations from insurance, bank and management perspectives are discussed. The commons of these for example the parties mixed up in moral hazard, the uncontrollable high-risk behaviour of one party whose benefits are guaranteed and the interpersonal costs which the situation brings. Risk way of measuring and control system should be created to reduce moral risk problem. Solutions such as risk-sharing insurance, significant fines of bad personal debt and long-term performance measurement are advised.
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